94 Figure 6.2: Inframarginal network externalities 6.2 General competition policy and network externalities The implementation of policy measures geared to internalizing external effects, for example the implementation of a Pigouvian tax, was traditionally considered a viable means of restoring efficient production in the presence of external effects.75 As is shown in Figure 6.1, internalizing Pareto-relevant network externalities requires that consumers gather on one uniform technology platform as long as the marginal social benefit from further network participation continues to be positive. However, when consumers derive utility not only from network size but also from product characteristics (the technology effect), internalizing network externalities in this way may not correspond to the social welfare maximizing solution. When consumers’ tastes for product characteristics differ, there may be a conflict between internalizing network externalities and catering to individual preferences. Consumers with heterogeneous tastes will not be able to agree on a single preferred set of product characteri- 75 See Baumol and Oates (1988) for an overview of the policy instruments which are applied so as to internalize external effects in the context of environmental management. p S MC MSB MBtotal MPB SpS* 95 stics. They may prefer to consume a variety of products offering less network benefits to compromising on product characteristics in order to maximize the utility received from belonging to one network. This problem is similar to the trade-off between optimal firm size and product variety in the context of production economies of scale discussed above.76 It was shown that with falling average costs over the relevant output region, exhausting production economies of scale is possible only at the expense of less product diversity in the market. Here, with strong network externalities in the market, the utility from network size can also only be increased at the expense of having less product variety in the market. As in the case of production economies of scale, it is possible that the increase in utility that consumers gain when consuming a product close to their individual preferences can suffice to compensate for the loss in utility from not having a larger network. When the optimal network size in a market featuring Pareto-relevant network externalities is not reached, this does not indicate a market failure when this is the result of consumer preferences for more product variety in the market. There is a further reason why social welfare optimization may not require that network externalities are exhausted by obliging all consumers to choose one technology platform. Only an environment that offers diversity will bring about product innovations. Innovations are important in dynamic markets with continual technological progress. Consumers participate in the search for better technologies by trying out new products. Markets featuring network externalities are at a disadvantage with respect to this competition of new ideas because new entrants offering newer technologies have no established customer base and can therefore not offer the same benefits from the network effect as established firms. Consumers may be reluctant to try out the new products which have a disadvantage in the network effect and offer only uncertain benefits with respect to their new product characteristics.77 Decentralized decision-making by consumers cannot solve the trade-off between externalities, variety and innovation. A single consumer cannot know which technology he would prefer in equilibrium without knowing how the other consumers in the market will decide. Policy intervention, however, also cannot help to resolve the conflict between network size, variety and innovation. Policy makers would need to know the individual consumers’ preferences and would have to have an accepted method of aggregating preferences in order to approximate a socially optimal policy. Furthermore, they would have to take into account the development of future technologies in order to be able to solve not only the conflict between network size and variety but also enable innovations. Given that this information cannot be obtained by policy makers, it is impossible for policy intervention to bring about a socially optimal outcome (Blankart and Knieps, 1994: 458). 76 See Section 4.3 above on the models of product differentiation. 77 See Blankart and Knieps (1994) for a more elaborate discussion of the trade-off between externalities, variety, and innovation. 96 This section has shown that calling for market intervention whenever externalities are suspected has many pitfalls. First of all, it is possible that the externalities in question are not of a technological nature, and, even if they were, they need not be relevant in market equilibrium. Secondly, even when network externalities are Pareto-relevant in equilibrium, there is a trade-off between network size, variety, and search for new technologies, such that internalizing the externalities is not necessarily the optimal solution from a social-welfare perspective. It was argued that neither decentralized decisions by consumers nor policy decisions can optimally solve the trade-off between these three goals. 6.3 Market processes in the presence of network externalities The focus in this section turns on whether markets can generate mechanisms by which the trade-off between network size, variety, and innovation can be resolved. Taking the limitations to policy intervention into account, it is obvious that market outcomes cannot and should not be measured against a hypothetical, unrealizable social optimum. Rather, the standard should be an outcome that can realistically be expected to emerge from the political process.78 According to Hayek (1945), the competitive process is the most efficient means of using the individual knowledge dispersed among the members of society.79 In his view, the market spontaneously directs the decentralized choices of consumers towards the common weal and it is much better at doing this than any centralized planning committee. The following sections will analyze whether such a belief in the ability of the market to coordinate decentralized decision-makers is warranted in the presence of network externalities or whether it is rather to be expected that market processes are severely inhibited in their proper functioning. There is a fairly broad body of theoretical economics literature on network externalities and their effect on market equilibrium.80 Typical research questions in this literature are: What influences consumers’ decisions on which network to join? How do firms decide whether to cooperate or not? How do the private and the social in- 78 In addition to the fact that politicians’ capability of identifying optimal policy intervention is limited because of lacking knowledge of the actual consequences of their actions, public choice theory (see e.g. Buchanan 1987) has pointed out that policymakers cannot simply be expected to be guided by the goal of maximizing public welfare. 79 Austrian economics in general rejects the concept of “social welfare” as a criterion against which market outcomes can be measured. From the point of view of Austrian economics “coordination efficiency”, by which is meant the ability of the market process to coordinate the actions of the individual members of a society, is an appropriate measure by which the functioning of the market can be evaluated. This concept reflects the relative importance of dynamic processes in Austrian economics as compared to the evaluation of transient equilibria (see Schmidtchen, 1990, especially 136f.). 80 Surveys of the literature on network externalities are for instance given in Farrell and Saloner (1987), Gilbert (1992), and Holler (1996).