92 While a static analysis is inappropriate to study external effects in the context of dynamic industries, the simple diagram depicted in Figure 6.1 suffices for the purpose of illustrating that in the presence of network externalities the equilibrium network size will generally be smaller than the socially optimal network size, such that the competitive equilibrium is likely to reflect an inefficient welfare loss. Figure 6.1 shows the marginal cost function (MC), the marginal private benefit (MPB), and the marginal social benefit (MSB) functions for a network good. The total benefit function (MBtotal) exceeds the private benefit function, because it includes the benefits that accrue to other users of the technology, when an additional user joins the network. In the social optimum, the level of network participation would be S*, in which the sum of the private and social benefits from further network participation (MBtotal) is equal to the marginal cost incurred by the marginal consumer. The private equilibrium Sp is smaller than S*, however, because a user will purchase the technology only when the private benefits received exceed the private marginal costs. The private consumption decision leads to too little network participation compared to the social optimum. Only coordination between the users of the technology can internalize the external benefits and increase network participation to S*. Existing consumers would, for instance, have to agree to subsidize the marginal consumer. The question of how and when users will coordinate their consumption decisions in the presence of network externalities will be taken up again in sections 6.3.2 and 6.3.3. 6.1.2 Direct and indirect network externalities The literature on network externalities distinguishes between direct network externalities and indirect network externalities (Katz and Shapiro, 1985: 424). The term direct network externalities refers to the immediate effect the size of a network has on the utility received from participation in that same network. The term indirect network externalities refers to the effect the size of a network can have on markets for complementary goods or services. When the number of subscribers of a network increases, this can positively affect the variety of complementary goods and services offered on complementary markets. A common illustration of indirect network externalities is the interrelationship between the diffusion of compact disc players and the variety of CDs offered. Early adopters of compact disc players experienced a utility increase from the later broader diffusion of CD players, because only then did the variety of CDs offered reflect the full spectrum of music styles. In general, it can be said that indirect network externalities often occur on markets interrelated by a so-called hardware/software relationship. 93 6.1.3 Pecuniary network externalities A further distinction made in the literature on externalities is the one between pecuniary network externalities and technological network externalities (Liebowitz and Margolis, 1994: 137). As will be shown below, pecuniary network externalities are demand effects that are transmitted through the price system, whereas technological network externalities impose benefits (or costs) outside of market mechanisms. Since pecuniary externalities are common in network industries, they will be considered in more detail. Pecuniary network externalities can result from an outward shift in demand in a decreasing costs industry. When the demand shift allows the producer to reach a lower level of production costs both new consumers and existing consumers benefit from a lower price level. Formally the utility increase to existing consumers could, of course, also be illustrated by the utility function Ui,j(S,T) that was introduced at the beginning of this chapter. However, the difference to “real” external effects is that in the case of pecuniary externalities the utility increase is only indirectly related to the number of network participants. The direct relationship is between the fall in prices, induced by increased participation, and the resulting increase in consumers’ surplus. Existing consumers appropriate the increase in consumer rents as a result of a functioning price system. So, in fact, with pecuniary externalities there is no external social benefit when an additional user joins the network. In a policy context it is important to distinguish the two effects. Pecuniary externalities should not attract policy intervention because they are a part of a functioning price mechanism. Technological externalities may, however, justify policy directed at internalizing the externality. 6.1.4 Pareto-relevance of network externalities Not all correctly identified technological network externalities result in too little network participation. External effects can be inframarginal, in the sense that they would not change the equilibrium outcome, even if they were internalized into the market mechanism (Liebowitz and Margolis, 1994: 140). Inframarginal externalities are realistic when a network community profits from increasing membership only up to a critical size, but further growth beyond that point would yield no further benefit. When the critical size of the network is small relative to the number of potential members, several networks can coexist and compete for membership. Figure 6.2 is a graphic illustration of inframarginal network externalities in a static environment. The marginal social benefit from further network participation is zero once network size has reached S*. Because the private equilibrium Sp, where marginal private benefits equal marginal private costs, is to the right of S*, the socially optimal equilibrium coincides with the private equilibrium.