Margit Vanberg, Case 2: Network externalities in a contestable natural monopoly in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 99 - 105

A Network Economic Analysis

1. Edition 2009, ISBN print: 978-3-8329-4163-5, ISBN online: 978-3-8452-1290-6

Series: Freiburger Studien zur Netzökonomie, vol. 14

Bibliographic information
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. 100 is a telephone network. In a world without interconnection, a user will not switch to a new telephone network featuring better technology at lower prices as long as there are no subscribers on that network to communicate with. If all consumers postpone the purchase of a product with network externalities until the critical mass is reached a cheaper product or a product of better quality would not be sufficient to gain a user base in the face of strong network externalities. The problem of reaching a critical mass does not compare to ordinary switching costs. Switching costs are a factor in many markets that do not feature network externalities. The difference between switching costs and the problem of critical mass is that in the case of ordinary switching costs a consumer can weigh her private costs and benefits from switching to a new product and make an informed choice. For instance, a consumer may consider it costly to learn to use a new mobile telephone of an unknown manufacturer when the new menu navigation is unfamiliar. She can compare these costs to the benefit received from the new phone in terms of new features, better design, lower price, etc. Liebowitz would argue that such switching costs “are real costs, and if the new product is not sufficiently better to outweigh those costs, then it is efficient for society to stick with the old” (Liebowitz, 2002: 36). Ordinary switching costs do not cause market failure. Rather, they deliver important information in the market process. Sufficiently superior products will overcome switching costs of this kind, and there are plenty of examples in real markets that give proof of this. What is different for consumers deliberating to switch products in a market exhibiting network externalities is the fact that the individual consumer does not have all the information needed to compare the relevant costs and benefits of switching. The individual’s costs and benefits from switching to the new product always depend on the product choice made by other consumers. For a single consumer to make an informed product choice all consumers would need to communicate their interests ahead of time. Given these difficulties, the economics profession has produced different viewpoints on the question of whether network externalities can substantially reduce the threat of potential competition and therefore lend market power to an otherwise contestable monopolist. While, for instance, Arthur (1989) and David (1985) argue that market equilibrium will be influenced to a significant degree by chance events, Katz and Shapiro (1994: 112) argue that “the market efficiency is unclear, once recognition is given to the many private institutions that arise to achieve coordination and internalize externalities. [...] there are many possible responses of systems markets to these problems that involve no government intervention whatsoever.” The following illustrates three aspects which have been shown to be important for achieving market coordination in the presence of network externalities. The role of information in overcoming the critical mass problem In a contestable natural monopoly the choice between technologies can be reduced to a two-dimensional choice between staying with the incumbent’s technology and switching to a new entrant’s technology. Farrell and Saloner (1985) model a very 101 similar market. Here n firms decide between a status quo standard T1 and a new standard T2. By assumption, all firms agree that the new standard is superior, but because of network externalities switching is only beneficial if all other firms switch. In equilibrium, i.e. when all firms have complete information on the other firms’ preferences, all firms will switch to the new standard.89 When the preferences of the other firms are not common knowledge, only those firms with a very high preference for the new product will switch early, and it is not clear whether all other firms will follow, even if the new standard is preferred by all consumers. Farrell and Saloner call this phenomenon “excess inertia.” When consumers have different preferences with respect to the two products it is also possible that “excess momentum” occurs. Those consumers that favor the newer product switch early and may come to regret their decision, when they are not followed by those users that prefer the established product. The Farrell and Saloner model focuses on the importance of information. In their model consumers need to be able to communicate their preferences in order to coordinate a switch that leads to a superior market outcome. Otherwise either excess inertia or excess momentum can leave some users stranded with a less-preferred technology. Central to the question of whether network externalities impede the efficient market process is therefore the likelihood of consumers succeeding in reducing the information problem by communicating their preferences. The role of consumer expectations in overcoming the critical mass problem The likelihood that consumers can spontaneously organize to systematically reveal to each other their product preferences depends to a large degree on the extent of the market. A small user group is more likely to achieve coordination than a market with many anonymous buyers. The latter case is modeled by Arthur (1989), who assumes a situation in which consumers have no further information on the prospects of a product except for the number of previous customers of the product. They decide which technology to use based only on the technological characteristics and on the number of existing users. The process of technology adoption is then stochastically determined by a chance sequence in which consumers make their technology choice. Arthur uses this model to show how historical events, even if insignificant at the time, play a significant role in the long-run adoption of products and technologies.90 Early events that, by chance, favor one technology will grant this technology a significant installed base such that when a superior product arrives on the scene at a later time, even those consumers that would prefer this newer product 89 This outcome results from the fact that each individual i ? (1,2,...n) prefers to switch to the new technology when all individuals 1, ... i-1 have already switched and when he believes the rest will switch when he switches. The individual i believes that i+1, ...n will switch when he switches because he knows that they have the same preferences as he does. Therefore individual i will switch and all others will follow (see Farrell and Saloner, 1985: 73). 90 David (1985: 332) speaks of “historical accidents” in this context. 102 will buy the inferior existing product as it offers the larger network benefit. Thus, according to this model, society can experience inefficient lock-in.91 Two assumptions are critical for Arthur to arrive at his prediction. First, consumer preferences for product characteristics (the technology effect) are exogenous to the model. They cannot be altered by making available newer information or by changing product characteristics. Second, the consumers’ utility is endogenously determined only by the number of existing users of a product (the network effect). Expectations of future consumption levels are not considered. As a result, only historical chance events influence the consumers’ decision which network to join. It is possible, however, that market participants undertake strategic actions to influence consumer expectations regarding future network size and changes in technology. Such strategic intervention can dominate the influence of random historical events. Larger consumer groups will often lack the organization necessary to reveal their preferences to each other. A new entrant, however, has opportunities to disclose relevant information on his product’s chances and to influence consumer buying decisions, and he obviously has an incentive to do so. As Liebowitz and Margolis (1990: 4) suggest: “An owner with the prospect of appropriating substantial benefits from a new standard would have an incentive to share some of the costs of switching to a new standard. This incentive gives rise to a variety of internalizing tactics.” These tactics are discussed in the following section. The role of sponsorship in overcoming the critical mass problem There is extensive research which focuses on the abilities of firms to “sponsor” their products in order to overcome the critical mass problem. Katz and Shapiro (1986), for instance, analyze technology adoption under the circumstance that a new entrant is willing to incur short-run losses in order to establish his technology. This model is interesting in the context of the contestable monopoly case discussed here, because it considers two competing technologies available in two time periods. Period-1 91 The best-known exponents of the theory of inefficient lock-in are David (1985) and Arthur (1989). See also Cowan (1991). Liebowitz and Margolis (1995) offer a very interesting critique of the literature on path-dependency and lock-in by differentiating three different forms of path-dependency of which only one leads to market failure in the sense that policy interventions can be shown to improve on the market outcome. This case presupposes that “there exists or existed some feasible arrangement for recognizing and achieving a preferred outcome, but that outcome is not obtained” (ibid., 207). The authors argue that this third case is based on restrictive and implausible assumptions, especially because it is assumed that at least one person must know of the better solution, but this person does not turn this knowledge into profit by coordinating buyers to the superior outcome (ibid., 217). Nevertheless, in academic discussions the policy implications of this case are applied to the two other more realistic cases of path-dependency, which assume that “the existence or superiority of alternative paths are not known at the time that initial decisions are made” (ibid., 211). Liebowitz and Margolis argue that in these cases there is no real inefficiency in the market outcome as there is no knowledge of the superior outcome in the economy. Then, however, these more common cases lack the strong policy implications of the case in which a superior outcome is known to be feasible. 103 consumers take into account the probable consumption decision of period-2 consumers when making their technology choice. Period-2 consumers make their technology choice dependent on the technology chosen in the first period. Preferences of consumers are assumed to be homogeneous and consumers are assumed to have rational expectations. In the first period, consumers unanimously choose the technology yielding the highest consumer surplus at that time. In the second period, consumers compare the benefit from the combined technology and network effects of both products. The second period is thus comparable to the contestable monopoly case in which a newer technology competes with an incumbent technology. The model assumes that the newer technology will win the market in the second period only when the extent of the price/quality superiority over the previous technology is worth more to consumers than the installed-base advantage that the existing technology offers. The authors thus emphasize the possibilities an entrant has to influence the price/quality superiority of his product. E.g., the entrant can differentiate his product so as to offer more benefits from the technology effect of his product. When consumers’ expectations of future network size factor into their benefit function, the new entrant also has the possibility of convincing consumers that his product will offer more benefits from the network effect in the future: early product announcement and a penetration-price strategy can, for instance, induce some potential first-period consumers to wait until the second period to make their purchase decision thereby decreasing the installed-base advantage of the first technology. Furthermore, this may convince new users that the entrant will pull sufficient demand to be able to offer similar network benefits than the incumbent.92 Katz and Shapiro (1986: 832) show that when neither of the two technologies is sponsored then there is a tendency in the market to standardize on the initially superior network, even when this is not the socially optimal outcome in later periods. This confirms Arthur’s (1989) result. However, when both technologies are sponsored, there is a tendency that the market will standardize on the technology that has lower costs in the second period (Katz and Shapiro, 1986: 838). Interpreting lower costs as a signal for a more advanced technology, this model shows that sponsoring can be an efficient means for a new entrant with a superior product to overcome critical mass restrictions. In addition to those already mentioned, an entrant can also use one of the following strategies to sponsor his product.93 Whenever consumer expectations of future market shares play a role, advertising can, for instance, increase a product’s reputation and influence the expected sales of a product. This will in turn increase the realized demand share in the present. The entrant can also make the price of his service dependent on network size. As long as the network is small, consumers pay a 92 In a related paper Farrell and Saloner (1986) analyze the welfare effects of product preannouncement and strategic pricing in dynamic markets with network externalities. 93 See also Katz and Shapiro (1994: 102). Witt (1997: 769) defines promotional activities by firms as efforts which “are undertaken during the promotion campaign to convince many potential adopters simultaneously that other consumers are also about to adopt the new variant.” 104 lower price. This pricing scheme acts as insurance for consumers. Only when network size increases will membership become more expensive. The risk of being stranded on the “wrong network” is thereby reduced. A further pricing strategy is to subsidize a basic service and thereby bind more consumers to a technology while adding mark-ups to advanced services and applications in order to cover the losses obtained on the basic service. Lastly, the entrant can use subscription to build a customer base before actually introducing his product. Consumers that subscribe in advance commit to switching to the new product once an appointed number of subscribers is reached. Public Policy for contestable markets featuring network externalities The discussion of the various ways in which consumer expectations, information dissemination and sponsorship can influence the market’s ability to achieve coordination even in the presence of network externalities shows, that the theory of inefficient lock-in may throw an overly pessimistic view on the problem of network externalities in contestable markets. For the purpose of deciding on whether or not to take policy measures in such markets it would be wrong to simply presuppose that a firm that so far was able to dominate a market has market power. Instead, it may well be that no superior product was as yet available to potential market entrants. From their studies of real-world examples Liebowitz and Margolis conclude that the dominance of a particular product can often be explained by superior quality and/or price advantages offered to consumers.94 Using Stigler’s definition of entry barriers they conclude: is unclear how network effects, economies of scale, or any of the other factors at work favor the incumbent relative to the challenger. The incumbent had to coordinate consumers to adopt his product, whether it was first in the market or replaced a previous incumbent. In either case, getting consumers to come on board is a cost imposed on all market entrants, late or early, and does not necessarily favor early firms (Liebowitz and Margolis, 2001: 164f.). Therefore, network externalities alone do not lend market power to a contestable natural monopolist, and policy interventions into the market process would not be 94 Liebowitz and Margolis have put the hypothesis of inefficient lock-in to an empirical test by analyzing real-world markets commonly associated with this phenomenon. In “The Fable of the Keys” (Liebowitz and Margolis, 1990) they investigate the history of the Qwerty keyboard, which has long served as the standard example for an inefficient lock-in, because it is argued to be inferior in terms of typing efficiency when compared to keyboards developed subsequently. In Liebowitz and Margolis (2001) they analyze the hypothesis of inefficient lock-in in a competitive context. They examine the claim that network effects in the software market are responsible for Microsoft’s success in particular product groups. In the antitrust case against Microsoft it was argued that Microsoft dominates particular software markets only because the software is part of the Microsoft operating system and not because of product quality and price advantages. Liebowitz and Margolis use software reviews from leading computer magazines to compare the product rankings according to expert opinions with measures of market share. They find that the market success of, for instance, the spreadsheet program Excel can also be explained by a quality lead over the competing product as well as competitive price setting. 105 justified. Rather, market institutions are creative in finding ways by which consumer preferences are revealed, such that network externalities can be internalized within regular market operations. Policy makers would find it difficult to improve on market outcomes. With respect to the allocative efficiency of the market outcome to be expected in an unregulated contestable market featuring network externalities, it can be said that, since the cost conditions of the market favor only one active firm, there is no threat of network islands developing. Furthermore, should the operator try to enforce a price above the competitive level, this would invite market entry. Only the competitive price protects the operator from replacement by a potential competitor. This competitive price level leads to a network size that internalizes the network externalities to a large degree (comparable to equilibrium Sp in Figure 6.1). 6.3.3 Case 3: Network externalities in a competitive market In a competitive market featuring substantial network externalities, firms will compete not only in price and product characteristics, but also in the dimension of network size. The stronger the network externalities, the more important will be the “network effect” a product offers compared to its “technology effect” (see section 6.1 above). The important difference to a contestable monopoly with network externalities is, that in a competitive market users have a choice between several operating networks. The trade-off between standardization and variety, mentioned in section 6.2, takes on its full meaning only in this context. An increased variety of technologies available for consumption makes it more difficult for consumers to resolve the trade-off between choosing the technology with the most preferred product characteristics and benefiting from being a part of a network with a large number of users. Generally, consumers can be expected to have different preferences with respect to their preferred technological and qualitative product characteristics and also different valuations of the network effect. It is therefore likely that consumers are better off when a variety of network islands caters to particular consumer tastes compared to one large network offering a compromise between the demanded product characteristics (Shy, 2001: 27f.). However, the more important the network effect, the more willingly will consumers give up specialized technologies and concentrate on the network offering the largest user base. The aim of this section is to understand how the competitive market process will solve the trade-off between taking advantage of network externalities (implicating a small number of active firms) and offering product variety and competition in the market (implicating a larger number of active firms). In contrast to the case of the trade-off between economies of scale and product variety, there is a solution to the trade-off between network externalities and product variety. Consumers can profit both from product variety and the positive network externalities when rival firms are willing to cooperate by making their networks

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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.