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Margit Vanberg, Case 1: Network externalities in a monopolistic bottleneck in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 96 - 99

A Network Economic Analysis

1. Edition 2009, ISBN print: 978-3-8329-4163-5, ISBN online: 978-3-8452-1290-6 https://doi.org/10.5771/9783845212906

Series: Freiburger Studien zur Netzökonomie, vol. 14

Bibliographic information
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). 97 centives for compatibility between competing technologies compare?81 Under what circumstances can a market tip in favor of inferior products or services and become “locked-in”?82 How should standards be set, i.e. is it optimal to leave standardization to market forces, should industry groups cooperate, or is it optimal to mandate standards?83 The majority of this industrial organizations literature on network externalities is embedded in an oligopoly context.84 The focus of this literature is on understanding firm behavior under given market conditions. In the context of the present research question, namely whether network externalities can cause market power, a major drawback of such a focus is that standard oligopoly models assume a fixed number of active firms, thereby presuming sources of market power which can later not be differentiated from market imperfections resulting from network externalities. In order to distinguish the effects of network externalities on market processes the following analysis uses the three market types differentiated by the disaggregated regulatory approach: (1) monopolistic bottlenecks, (2) contestable markets, and (3) active competition. Differentiating between these three cases helps to clarify whether there is already market power in a market due to asymmetric cost advantages of the incumbent firm, as in the case of monopolistic bottlenecks. In the other two market types, either active or potential competition hinders firms from making above competitive profits. When network externalities are added to these three distinct cases it becomes apparent whether network externalities can be an original source of market power in the case of active or potential competition, and whether network externalities strengthen market power in the case of monopolistic bottlenecks.85 6.3.1 Case 1: Network externalities in a monopolistic bottleneck Non-contestable natural monopolies are characterized by cost subadditivity in the relevant output region paired with sunk costs of production.86 In chapter 5 it was argued that monopolistic bottlenecks, i.e. network areas showing both of these cha- 81 For the first three questions see the seminal papers on network externalities in an oligopoly context by Farrell and Saloner (1985, 1986) and Katz and Shapiro (1985, 1986). 82 See, for instance, David (1985) and Arthur (1989). 83 See, for instance, Farrell and Saloner (1988) and Gandal (2002). 84 See, for instance, the seminal articles in this type of literature by Katz and Shapiro (1985) and Farrell and Saloner (1985). 85 Blankart and Knieps (1995) organize their analysis of the need for ONP (open network provision) regulation in networks exhibiting both network externalities and economies of scale in a very similar way. They differentiate the three market types mentioned above on both sides of the market (supply-side and demand-side). Their analysis therefore covers nine different scenarios. The analysis here presupposes competitive conditions on the demand-side of the market and therefore differentiates only a subset of the scenarios treated by Blankart and Knieps. 86 See section 4.3.1 above. 98 racteristics, lend network-specific market power to the owner of the monopolistic bottleneck and therefore justify sector-specific regulation. When network externalities are present in a monopolistic bottleneck network area, the monopolists’ profit maximization behavior will generally lead to a market outcome that is not compatible with exhausting the direct network externalities in the market. Farrell and Saloner (1992:13), for instance, argue that when a monopolist cannot price-discriminate, he will not be able to appropriate the utility increase that existing consumers experience through a higher subscription rate. Rather, a monopolist, who is constricted to linear prices, will continue to maximize profits by maximizing the willingness to pay of the marginal consumer. The monopolist’s price will take into account the marginal consumer’s valuation of the network externalities, but not the valuation of the increased network size by all inframarginal users. Compared to a competitive market outcome, the monopoly price (above marginal cost) will aggravate the problem of too little network participation (Katz and Shaprio, 1994: 101).87 In a static market environment, the market equilibrium will be to the left even of the private equilibrium Sp in Figure 6.1. Monopolists have an incentive to transfer market power from already monopolized markets to vertically and horizontally related markets. Indirect network externalities, which affect markets complementary to the monopolistic bottleneck area, can provide the monopolist with the necessary prerequisites to pursue such strategies. For instance, when complementary markets are dependent on a common standard with the monopolistic bottleneck, the owner of the monopolistic bottleneck could refuse non-discriminatory open standards to competitors. As an example consider markets characterized by a hardware/software relationship. If the hardware market were a monopolistic bottleneck, producers of related software would depend on open standards, which the monopolist could refuse in favor of an integrated or a cooperating software producer. Public policy for monopolistic bottleneck areas featuring network externalities The presence of network externalities in a non-contestable natural monopoly will not reverse the fact that the owner of a monopolistic bottleneck has network-specific market power. Rather, indirect network externalities can help the monopolist to extend market power to related markets. Therefore, network externalities increase the need for regulation in the monopolistic bottleneck area. In addition to openaccess regulation of the monopolistic bottleneck, there is a need to pay attention to complementary markets and compatibility issues. Open standards need to be enforced, such that competitors on vertically and horizontally related markets benefit 87 In a slightly different partial equilibrium oligopoly model, Katz and Shapiro (1985) argue that under the assumption that consumer expectations on network size be fulfilled in equilibrium, a monopoly context will lead to consumers expecting the network size to be smaller compared to a competitive market. Automatically consumers therefore adjust their willingness to pay for the network service downward in a monopoly context. This decreases the willingness to pay and ultimately reduces even further the equilibrium network size. 98 racteristics, lend network-specific market power to the owner of the monopolistic bottleneck and therefore justify sector-specific regulation. When network externalities are present in a monopolistic bottleneck network area, the monopolists’ profit maximization behavior will generally lead to a market outcome that is not compatible with exhausting the direct network externalities in the market. Farrell and Saloner (1992:13), for instance, argue that when a monopolist cannot price-discriminate, he will not be able to appropriate the utility increase that existing consumers experience through a higher subscription rate. Rather, a monopolist, who is constricted to linear prices, will continue to maximize profits by maximizing the willingness to pay of the marginal consumer. The monopolist’s price will take into account the marginal consumer’s valuation of the network externalities, but not the valuation of the increased network size by all inframarginal users. Compared to a competitive market outcome, the monopoly price (above marginal cost) will aggravate the problem of too little network participation (Katz and Shaprio, 1994: 101).87 In a static market environment, the market equilibrium will be to the left even of the private equilibrium Sp in Figure 6.1. Monopolists have an incentive to transfer market power from already monopolized markets to vertically and horizontally related markets. Indirect network externalities, which affect markets complementary to the monopolistic bottleneck area, can provide the monopolist with the necessary prerequisites to pursue such strategies. For instance, when complementary markets are dependent on a common standard with the monopolistic bottleneck, the owner of the monopolistic bottleneck could refuse non-discriminatory open standards to competitors. As an example consider markets characterized by a hardware/software relationship. If the hardware market were a monopolistic bottleneck, producers of related software would depend on open standards, which the monopolist could refuse in favor of an integrated or a cooperating software producer. Public policy for monopolistic bottleneck areas featuring network externalities The presence of network externalities in a non-contestable natural monopoly will not reverse the fact that the owner of a monopolistic bottleneck has network-specific market power. Rather, indirect network externalities can help the monopolist to extend market power to related markets. Therefore, network externalities increase the need for regulation in the monopolistic bottleneck area. In addition to openaccess regulation of the monopolistic bottleneck, there is a need to pay attention to complementary markets and compatibility issues. Open standards need to be enforced, such that competitors on vertically and horizontally related markets benefit 87 In a slightly different partial eq ilib ium oligopoly model, Katz and Shapiro (1985) argue that under the assumption that consumer exp ctations o network size be fulfilled in equilibrium, a monopoly context will lead to c nsumers expecting the network size o be sma er compared t a competitive market. Automatically consumers th refore a just th ir willingness to pay for the network service downward in a monopoly context. This decreases the willingness to pay and ultimately reduces even further the equilibrium network size. 99 equally from indirect network externalities that emanate from the monopolized market. For example, product compatibility between the monopolist’s bottleneck products and the products of the competition should be ensured, such that an increase in the monopolist’s output initiates demand effects not only for the monopolist’s complementary products but also for the products of independent competitors. Who will decide on the standards to be adhered to by the bottleneck owner is a further question policy makers must decide. Allowing the monopolist to determine standards may give him a chance to discriminate competitors. When it is possible, a contest for best standard could be held before monopoly is awarded in a market (Blankart and Knieps, 1995: 289ff.). This is, however, feasible only prior to product introduction. Very often the need for a new standard evolves in markets of established products when a new application is introduced. In these cases the regulation of open standards must be designed carefully. Both the monopolist and its competitors have a legitimate interest in influencing the standard because they have the best knowledge of the technical and qualitative requirements of their applications. Governments may be prone to promote standards, which serve their own interests, rather than society’s interests. The standard-setting process has to take these aspects into consideration. This discussion is taken up again in section 6.3.4. 6.3.2 Case 2: Network externalities in a contestable natural monopoly A contestable natural monopoly can support only one active firm. The monopolist does not possess network-specific market power because the possibility of market entry by potential competitors disciplines the monopoly supplier. Potential competitors have access to the same cost function as the active firm because market entry does not require investing into irreversible assets. Under these conditions, a potential competitor will enter the market and undersell the monopolist should he be charging super-competitive rates.88 The effectiveness of potential competition hinges on the readiness of consumers to switch to the new entrant’s product when it is offered at superior conditions. The relevant question for the present analysis is whether the willingness of consumers to switch to a superior product is changed when there are network externalities in a contestable market. Some economists have argued that network externalities can hinder new entrants from establishing themselves even when they have an objectively superior product to sell. This assumption of so-called “inefficient lock-in” is seen to result from the fact that a product featuring network externalities has to gain a critical mass of users in order to become viable. When network externalities are strong, a new product will fail to be of any noteworthy use to consumers until a required minimum of other users (the critical mass) is reached. An obvious example 88 When the entrant has not reached the scale economies of the incumbent, his actual production costs will exceed the incumbent’s costs. However, because the entrant expects to replace the incumbent, he is willing to sell at prices equivalent to the long-run minimum average costs.

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Zusammenfassung

Die Konvergenz der Netztechnologien, die dem Internet, der Telekommunikation und dem Kabelfernsehen zu Grunde liegen, wird die Regulierung dieser Märkte grundlegend verändern. In den sogenannten Next Generation Networks werden auch Sprache und Fernsehinhalte über die IP-Technologie des Internets transportiert. Mit den Methoden der angewandten Mikroökonomie untersucht die vorliegende Arbeit, ob eine ex-ante sektorspezifische Regulierung auf den Märkten für Internetdienste wettbewerbsökonomisch begründet ist. Im Mittelpunkt der Analyse stehen die Größen- und Verbundvorteile, die beim Aufbau von Netzinfrastrukturen entstehen, sowie die Netzexternalitäten, die im Internet eine bedeutende Rolle spielen. Die Autorin kommt zu dem Ergebnis, dass in den Kernmärkten der Internet Service Provider keine monopolistischen Engpassbereiche vorliegen, welche eine sektor-spezifische Regulierung notwendig machen würden. Der funktionsfähige Wettbewerb zwischen den ISP setzt jedoch regulierten, diskriminierungsfreien Zugang zu den verbleibenden monopolistischen Engpassbereichen im vorgelagerten Markt für lokale Netzinfrastruktur voraus. Die Untersuchung zeigt den notwendigen Regulierungsumfang in der Internet-Peripherie auf und vergleicht diesen mit der aktuellen Regulierungspraxis auf den Telekommunikationsmärkten in den Vereinigten Staaten und in Europa. Sie richtet sich sowohl an die Praxis (Netzbetreiber, Regulierer und Kartellämter) als auch an die Wissenschaft.