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
106
compatible. Compatibility between otherwise self-contained network islands allows
users to communicate and share network benefits across networks, while competition is preserved in product dimensions not affected by the cooperation.95 With full
compatibility the consumer will base his product choice on technological characteristics and price. Network reach will be the same for all products. The main question
for the present analysis is what incentives firms in a competitive market have to
make their networks compatible.
Firm incentives for compatibility
When network externalities are strong and the consumer valuation of compatibility
accordingly high, the question is whether firms are likely to voluntarily engage in
cooperation while salvaging competition in product characteristics. Or is it more
likely that larger firms will decline cooperation in the hopes of gaining a competitive
advantage from offering the largest network? Can a larger network charge higher
prices and make above competitive profits in competitive markets with strong network externalities?
To answer this question it is useful to consider the costs and benefits of cooperation from the perspective of the firm. Most substantial on the cost side is that, by
making its network compatible, a firm gives up network size as a differentiating
product characteristic in its competition with rival firms. This aspect is especially
costly to firms with initially large networks. Furthermore, cooperating firms have to
invest more in product differentiation with respect to remaining differentiating characteristics. Lastly, there are transaction costs involved in coordinating the cooperation of firms with conflicting interests.
The most substantial of the positive aspects of compatibility is the possibility to
benefit from a significant demand shift generated by the increase in overall network
size. When total demand for network services rises due to several networks becoming compatible, then even initially large networks can experience a demand
increase for their network services. Economides (1996), for instance, shows that
even a monopolist can profit from inviting entrants, even subsidizing their market
entry, and making his services compatible to theirs. This counterintuitive result can
nonetheless be explained easily: when consumer demand is a function of the expected network size, and when network externalities are sufficiently strong, then the
demand effect from a larger network pushes the demand curve outwards to such an
extent that the higher market-wide sales allow the monopolist to sell so much more
of his product compared to the monopoly output that, even at a lower price, he can
95 Put differently, supply-side scale economies determine the cost-efficient physical network
size, while user externalities determine the efficient number of compatible network users.
Since physical network size cannot be shared between independent network owners, supplyside economies of scale lead to higher firm concentration in a market. User externalities do
not have this inevitable effect, since the “user size” of a network can be shared through cooperation.
106
compatible. Compatibility between otherwise self-contained network islands allows
users to communicate and share network benefits across networks, while competition is preserved in product dimensions not affected by the cooperation.95 With full
compatibility the consumer will base his product choice on technological characteristics and price. Network reach will be the same for all products. The main question
for the present analysis is what incentives firms in a competitive market have to
make their networks compatible.
Firm incentives for compatibility
When network externalities are strong and the consumer valuation of compatibility
accordingly high, the question is whether firms are likely to voluntarily engage in
cooperation while salvaging competition in product characteristics. Or is it more
likely that larger firms will decline cooperation in the hopes of gaining a competitive
advantage from offering the largest network? Can a larger network charge higher
prices and make above competitive profits in competitive markets with strong network externalities?
To answer this question it is useful to consider the costs and benefits of cooperation from the perspective of the firm. Most substantial on the cost side is that, by
making its network compatible, a firm gives up network size as a differentiating
product characteristic in its competition with rival firms. This aspect is especially
costly to firms with initially large networks. Furthermore, cooperating firms have to
invest more in product differentiation with respect to remaining differentiating characteristics. Lastly, there are transaction costs involved in coordinating the cooperation of firms with conflicting interests.
The most substantial of the positive aspects of compatibility is the possibility to
benefit from a significant demand shift generated by the increase in overall network
size. When total demand for network services rises due to several networks becoming compatible, then even initially large networks can experience a demand
increase for their network services. Economides (1996), for instance, shows that
even a monopolist can profit fro inviting entrants, even subsidizing their market
entry, and making his services compatible to theirs. This counterintuitive result can
nonetheless be explained easily: hen consumer demand is a function of the expected network size, and when network externalities are sufficiently strong, then the
demand effect from a larger network pushes the de and curve outwards to such an
extent that the higher market-wide sales allow the monopolist to sell so much more
of his product compared to the monopoly output that, even at a lower price, he can
95 Put differ ntly, supply-side scale economies determi e the c st-efficient physical network
size, w ile user exte nal ties determine th efficient number of compatible network users.
Sinc physical network size cannot be shared between independent network owners, supplyside economies of scale lead to higher firm concentration in a market. U er externalities do
not have this inevitable effect, since the “user size” of a network can be shared through cooperation.
107
increase his profit.96 The former monopolist can realize this output level and this
price only in a competitive setting. As a monopolist he cannot credibly commit to
producing a competitive output/price combination because, given a level of demand,
it is always in the monopolist’s interest to restrict output and raise prices. Since
consumers expect the monopolist to offer network services only at higher prices,
they expect a smaller network in a monopoly and their demand at any given price
will be correspondingly lower in a monopoly than in a competitive market.
A further benefit to cooperation is that it eliminates competition to establish the
largest network and therefore frees resources, which can be put to other uses. These
can, for instance, be invested into competing in other product characteristics. The
more important technological differentiation is to consumers, the more important it
will be to invest into product innovations. It can be shown that, ceteris paribus, firm
incentives for compatibility are higher in markets characterized by product differentiation (Farrell and Saloner, 1992; Doganoglu and Wright, 2006). Since product
innovations are likely to be of greater significance in dynamic markets, such markets
may also be more likely to show compatibility among firms.
A model of network externalities in Cournot competition
There is no reference model for the case of network externalities in competitive
markets. Models dealing with several competitors in markets featuring strong network externalities generally do not allow for free market entry. Rather they model
compatibility choice in Cournot competition between a fixed number of firms. The
present section discusses why the results of these models cannot be transferred to a
free-entry market environment.
The seminal paper on network externalities in oligopolistic competition is Katz
and Shapiro (1985). The authors analyze equilibrium outcomes and firm incentives
for compatibility. The model defines a consumer’s utility as:
Ui,j(S,T) = ri + v(Sje) for consumers i = 1,2,...m and technologies j = 1,2,...n.
Parameter ri stands for the basic willingness to pay for network services (this is the
willingness to pay which results from the “technology effect”). As technologies are
assumed to be homogeneous in all characteristics but network size, r does not differ
across technologies j, but only across consumers i, assumed to have different basic
valuations of network services. The parameter r is assumed to be uniformly distributed between minus infinity and A with density one, and A is assumed to be a
positive value.97
The consumer’s valuation of the network externality is expressed in the externality function v(Sje), where Sje is the sum of the network users expected to be compa-
96 The elasticity of demand obviously plays an important role in this context. The more elastic
the demand, the more pronounced will be the demand expansion induced by more rivalry in
the market.
97 These assumptions on the distribution of r ensure a linear demand curve for technology j.
108
tible with technology j. All consumers have the same valuation of the network effect. The model assumes v‘(Sje) > 0, v‘‘(Sje) < 0 and lim v‘(Sje) = 0 as v‘(je)??.
Users counted among Sje are either subscribers of technology j or subscribers of
networks compatible with technology j. When xke stands for the expected network
size of technology k, Sje can be expressed as:
where k = 1,2,...m are the networks compatible with j.
The static, one period model is solved in three steps. In a first step consumers
build expectations about the future network size associated with each technology. In
a second step firms choose their output given the consumer expectations of network
size and assuming the output of rival firms as given (Cournot competition).98 This
output game determines the prices that firms charge in equilibrium. In a third step,
consumers make their purchase decision by maximizing their utility. When the price
of a technology is given by pj, a consumer chooses the technology for which utility
is maximized (and is equal to or greater than the utility realized with the next best
alternative resource utilization). Formally, the consumer’s decision function is:
Assuming that Umin is equal to zero, the consumer maximizes
If this expression is negative for all available technologies j the consumer will join
none of the available networks.
Since the consumer’s basic willingness to pay ri is the same for every available
technology j, the consumer will choose that technology for which the difference
[v(Sje) - pj] is maximized, respectively that technology for which the price adjusted
for the network effect offered by a particular technology, [pj - v(Sje)], is minimized.
Katz and Shapiro call this price the “hedonic price” of technology j (Katz and Shapiro, 1985: 427).
Since all consumers are assumed to have the same evaluation of the network externality, all consumers will choose the technology that is available at the lowest
hedonic price. Therefore, the equilibrium will only feature more than one firm with
positive output, if these firms offer their technology at the same hedonic price.
98 The model assumes constant marginal costs.
( )[ ] min, ,max UpTSU jjij ??
( ) ( ) jejijji pSvrpTSU ?+=?,,
?
=
=
m
k
e
k
e
j xS
1
109
The equilibrium concept employed in the model is that of fulfilled expectations
Cournot equilibrium (FECE). This concept assumes that all firms maximize their
profits by choosing their output. Consumer expectations and the output level of rival
firms are given. Production costs are assumed to be the same for all firms; all costs
are non-variable. In equilibrium expected sales must be equal to actual sales.
Assuming that fixed costs are zero and redefining ri as the willingness to pay
which exceeds marginal costs, allows the authors to set up a profit function, which,
differentiated with respect to output, yields output equations for all firms. Solved
simultaneously, these equations yield the following equilibrium output:
Since the number of active firms n is exogenous to the model, the model leads to the
conclusion that those networks which consumers expect to be dominant (high value
of v(Sje)), for instance because of their initial network size or because of their reputation, will in fact be dominant in equilibrium (high xj*). Therefore, within their
framework, the authors conclude that network externalities lend market power to
initially large firms.
Discussion of the model
The equilibrium outcome that those networks that consumers initially expect to
become dominant will in the end dominate the market is a result of the specifications
of the model. Particularly, the model does not include a positive value to product
variety. For consumers to value variety, the parameter r, reflecting the willingness to
pay for the technological characteristics, would have to vary in technologies j. If this
were the case, then not all consumers would prefer the same network, even if their
valuation of the network externality were the same. Consumer expectations of network size would then not necessarily dominate the consumer’s choice of network.
Furthermore, the assumption that all consumers have the same valuation of the network effect is unrealistic, and at the same time very restrictive with respect to the
results of the model. Lifting these assumptions would allow different combinations
of price, technological characteristics, and network size to exist simultaneously in
the market. The result that networks that have an initially large user-base will come
to dominate a market would no longer hold. More realistic market conditions (heterogeneous consumers, product differentiation, and free market entry) are likely to
lead to more firms in equilibrium.
Katz and Shapiro analyze how the result would change if the assumption of a
fixed number of firms is lifted and instead the number of firms is assumed to increases indefinitely. The equilibrium output would then converge on:
( ) ( )1* +÷??
?
??
?
??+= ?
?
nSSvnAx
jk
e
k
e
jj
110
In words, as the number of firms grows, firm j’s equilibrium output will be the larger, the larger the expected network size of firm j is compared to the network sizes
of its competitors. When firms are expected to have the same network size in equilibrium, either because of full compatibility in the market or because firms are
grouped in network islands of equal size, then the equilibrium output of each single
firm will tend towards zero (because the second term of the above equation, will
tend towards v(Ske), and v(Ske) is equal to v(Sje), when networks are symmetric).
Using this result, Katz and Shapiro (1985: 429) show that when there is full compatibility between all active firms, then there is a unique symmetric equilibrium, which
converges on the perfectly competitive equilibrium, when the number of firms becomes increasingly large.
This competitive case analyzed by Katz and Shapiro is trivial. Since the model
does not allow competition by product differentiation the firms are homogeneous
whenever there is full compatibility. Compatibility in this setting takes away the last
differentiating aspect, namely network size. Naturally a market with an infinite
number of homogeneous firms will converge on the perfectly competitive equilibrium. A realistic model of competition, which would allow different consumer valuations of technological characteristics and network size, would not predict perfect
competition in a competitive market featuring network externalities. This is, however, as was already stated above, not the criterion against which market performance should be measured.
A more promising approach for understanding firm incentives for compatibility in
competitive markets is to analyze the difference in realized profit from the noncompatibility case to the compatibility case. Katz and Shapiro (1985) show that
within their framework not all suppliers benefit from increased compatibility. Even
when overall output rises, initially large networks may have a lower output in a
compatible equilibrium. When the possibility that firms make side-payments among
one another is considered, then it suffices that average profits in the market increase
as a result of cooperation for firms to voluntarily agree on compatibility. Those
firms that gain disproportionately from compatibility can compensate the losses of
those firms that would otherwise prefer not to cooperate.99 Because the condition
that average profits rise for compatibility to be a viable outcome is less restrictive
than the condition that profits increase individually, side-payments increase the
99 There are strong parallels here to the Coase Theorem, which postulates that as long as property rights are well-defined, private negotiations can lead to efficient market outcomes. See
also Katz and Shapiro (1986: 825).
( ) ( ) ( )?????? +÷?= ?????? jk eknejjn nSvSvx 1limlim *
110
In words, as the number of firms grows, firm j’s equilibrium output will be the larger, the larger the exp cted network size of firm j is compared to the network sizes
of its competitors. Wh n firms are expected to have the same ne work size in equilibrium, eith r because o full compatibility in the market or because firms are
g ouped n network islands of equal size, then the equilibrium output of each singl
firm will tend t wards zero (because the s cond term of the above equ tion, will
tend towards v(Ske), and v(Ske) is equal to v(Sje), when networks ar symmetric).
Using this result, Katz and hap ro (1985: 429) sho that when there is full compatib lity between all ctive firms, then there is a unique symmetric equil bri m, which
converges on the perfectly competitive equilibrium, when the number of firms bemes increasingly large.
This competitive case analyzed by Katz and Shapiro is trivial. Since the model
does not allow competitio b product differentiation the firms are homogeneous
whenever there is full compatibility. Compatibili y in this setting t k s away the last
differ ntia ing a pect, namely network size. Naturally a market with an infinite
numb r of homogeneous firms will converg on the perfectly competitive equil brium. A realistic mod l of co petition, which would allow different consumer valua
tions of technological charact r stics and network size, would ot predict perfect
c mpetition in a competitive market featuring network externalities. This is, however, as was already stated above, not he criterion against which market perfor
mance hould be measured.
A more promising approach for understanding firm incentives for compatibility in
competitive markets is to nalyze the difference in realized profit from the nona bility cas to the compatibility case. Katz and Shapiro (1985) show that
within their fram w rk not all suppliers benefit from increased compatibility. Even
hen ov rall output rises, initially la ge networks may h ve a lower output in a
compatible equilibrium. When the possibility that fir s make side-paymen s among
one anoth r is cons dered, then it suffices that average profits in the market increase
as a result of cooperation for firms to voluntarily agree on compatibili y. Tho
firms that gain dis roportionately from compatibility can c mpensate the losses of
those firms that would otherwise prefer not to cooper te.99 Because the c nditi n
at average profits rise for compatibility to be a viable outcome i less restric ive
n the condition that profits increase individually, side-payments increase th
99 There are strong parallels here to the Coase Theorem, which postulates that as long as property rights are well-defined, private negotiations can lead to efficient market outcomes. See
also Katz and Shapiro (1986: 825).
( ) ( ) ( )?????? +÷?= ?????? jk eknejjn nSvSvx 1limlim *
111
likelihood that firms reach a mutually beneficial compatibility agreement, even
when they are of substantially different initial size.100
Public policy for competitive markets featuring network externalities
The above discussion shows that cooperation is likely in competitive markets with
substantial network externalities when (1) consumer tastes vary, (2) when firms have
the possibility to differentiate their services (not only in network size, but also along
technological and qualitative characteristics) and (3) when compensation for compatibility is possible. Side-payments should not be interpreted as reflecting market
power. Rather, they redistribute the gains from network compatibility in a way that
all firms are better off.
In conclusion, there are many reasons for firms in competitive markets to voluntarily agree on compatibility when strong network externalities are present. It is not
possible to derive a general justification for interventions by competition policy in
the presence of network externalities. If competition authorities consider it necessary
to intervene into a competitive market on the grounds of market power caused by
strong network externalities, they need to prove for this particular case that the
above mentioned prerequisites for compatibility are not fulfilled, and that there
exists a large firm which is abusing its market position, earning above competitive
profits.
6.3.4 Compatibility standards
Before network services can become compatible across network boundaries technological requirements will have to be fulfilled. How do firms decide on a standard
to which all compatible networks have to conform? One can differentiate between
three general mechanisms by which compatibility between firms can be reached.
The first is standardization by multilateral agreement. For this the firms convene in
standardization committees charged with reaching a consensus on a particular product standard. The second mechanism is a unilateral predetermination of a particular
standard by a leading firm in the industry. The remaining firms either adopt this
standard or employ adapters or gateway technologies in order to make their products
compatible to the standard set by the industry leader. Lastly, an industry standard
can be imposed by governmental decree.
100 Compensation here refers strictly to payments made in order to induce the other party to agree
on a common standard. These payments have to be differentiated clearly from payments
which are compensation for costs incurred by the other party as a consequence of the compatibility. For example, if one network offers another network free licenses for its software products in order to induce it to agree to interconnect this can be considered a side-payment.
When, however, payments flow in direct relation to the costs of achieving compatibility, such
as transportation compensation for the costs incurred in terminating one another’s traffic, then
these payments do not reflect side-payments.
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References
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.