Network Issues Chapter 24 Network Issues 1 Introduction

Network Issues Chapter 24: Network Issues 1

Introduction • Some products are popular with individual consumers precisely because each consumer places a value on others using the same good – A telephone is only valuable if others have one, too – Each user of Microsoft Windows benefits from having lots of other Windows users • Users can run applications such as Word on each other’s computers • More applications are written for operating systems with many users • Network Effects or network externalities reflect such situations in which each consumer’s willingness to pay for a product rises as more consumers buy it • Strategic interaction in a market with network effects is complicated Chapter 24: Network Issues 2

Monopoly Provision of a Network Service • An early model by Rohlfs (1974) illustrates many of the issues that surround markets with network effects – Imagine some service, say a cable network, where consumers “hook” up to the system but the cost of providing them service after that is effectively zero • The provider is a monopolist and charges a “hook up” fee but no other payment • The basic valuation of the product vi is uniformly distributed across consumers from 0 to $100. Consumer willingness to pay is fvi where f is the fraction of the consumer population that is served • The ith’s consumer’s demand is: • qi. D = 0 if fvi < p 1 if fvi p Chapter 24: Network Issues 3

Monopoly Provision of a Network (cont. ) • Consider the marginal consumer with basic valuation • The firm will serve all consumers with valuations greater than • Solving for the fraction f of the market served we have: f=1 • = 1 – p/100 f So, the inverse demand function is: p = 100 f(1 – f) Chapter 24: Network Issues 4

Monopoly Provision of a Network (cont. ) • The inverse demand curve has both upward and downward sloping parts. This means that there are two possible values for the fraction of the market served at any price p. $/unit = p 25 $22. 22 20 15 10 5 0 0 0. 2 0. 4 f. L 0. 6 0. 8 1 f f. H Chapter 24: Network Issues 5

Monopoly Provision of a Network (cont. ) • The Rohlfs model makes clear many of the potential problems that can arise in markets with network effects • 1. The market may fail altogether – Suppose the firm must set a fee over $30 perhaps to cover fixed costs – Network will fail even though it is socially efficient • When half the market is served, the customers hooking up have vi ‘s that range from $50 to $100 or fvi values that range from $25 to $50 • Average value is then $37. 50, well above $30 • But as p rises to $30, f falls and so does average willingness to pay • There is no price at which sufficient numbers of consumers sign on that yields an average willingness to pay of $30 Chapter 24: Network Issues 6

Monopoly Provision of a Network (cont. ) • 2. There are multiple equilibria – At p < $25, there is more than one equilibrium value of f – Thus, at p = $22. 22 both f. L(p) = 1/3 and f. H(p) = 2/3 are possible values of f – Lower fraction may be unstable (tipping) • This group is comprised of consumer with top one-third of vi values • The addition of one more consumer will raise willingness to pay sufficiently that consumers with the next highest third of vi values will be willing to pay and we will move to the f. H equilibrium • The loss of one consumer will lower the willingness to pay of that same top one-third and demand will fall to zero at p = $22. 22 – If the firm needs to serve more than one-third of consumers at a price of $22. 22, f. L is called a critical mass. • Low or free introductory pricing • Lease and guarantee that if critical mass is not reached, refund given • Target large consumers with internal networks first Chapter 24: Network Issues 7

Networks, Complementary Services, and Competition • Rohlfs model is a monopoly model but has clear insights for oligopoly setting – Market may fail – Competition will be fierce—a firm that fails to reach a critical mass isn’t just smaller than its rival—it dies – Multiple Equilibria are possible, e. g. , Betamax versus VHS—either system and not necessarily the best one may be the winner Chapter 24: Network Issues 8

Systems and Standards Competition between networks does not always lead to one survivor • Each network may have its own system – Compatibility issues – What is gained and lost when consumers cannot use their brand of the product on other systems? • Competition to be the Industry Standard – Firms may compete to have their system adopted as the industry standard – What are the implications of standards competition? Chapter 24: Network Issues 9

Fear of being incompatible. Compatibility can Competition and Technical Both lead to the inferior Nash Equilibrium— Both The fight over compatibility can lead to poor technical switching to neither firm switches because it choices staying withoverall the new thinks the other won’t switch the old possible problems are Excess Inertia and Excess Two technology is Momentum technology a superior is a Nash Firm 1 Equilibrium m Excess Inertia Old New Firm 2 Technology Old Technology (5, 4) (2, 2) New Technology (1, 5) (6, 7) Chapter 24: Network Issues 10

Both staying switching to Compatibility (cont. ) with the old Technical Again, fear of being incompatible can thesame new technology is of In the case excess inertia, each firm. Equilibrium wants to adopt the lead to the inferior Nash technology as its rival but, fearful that the rival won’t switch to a superior the new technology, each wrongly stays with the old is a Nash It is also possible that there is Excess Momentum and. Equilibriu each Equilibrium wrongly switches to the New Technology m Firm 1 Excess Momentum Firm 2 Old Technology New Technology Old Technology (6, 7)) (2, 2) New Technology (1, 5) (5, 4) Chapter 24: Network Issues 11

Systems Competition and Industry Standards • The Excess Inertia and Excess Momentum cases apply to market settings where the network gains from compatibility and “connectedness” are large – both firms want to adopt a common technology – Difficulty in agreeing which technology both should use • Sometimes firms will not have a preference to make their technology the common standard or not to have a common technology at all – Different technologies loses compatibility – But different technologies differentiates each product and softens price competition, e. g. , Play. Station 2 vs. Gamecube vs. X-Box Chapter 24: Network Issues 12

Firm 1 choosing technology 1 and Technical Compatibility (cont. ) 2 and STRATEGIES: technology Firm 2 there choosing Assume technologies, Firmby 1’s technology 1 and Firm 2 choosing • are two build an early lead establishing Firm 2’s technology 1 aislarge the 2 installed base; and 2) technology convince 2 is the Nash Equilibrium In Battle of the Sexes firms still of agree that there should be a common Nash Equilibrium the suppliers complements to standard but each wants its own technologypreferred to be the standard preferred by Firm 1 your adopt preferred technology by Firm 2 Firm 1 Battle of the Sexes Technology 1 Technology 2 Technology 1 (8, 12) (5, 4) Technology 2 (6, 5) (10, 7) Firm 2 Chapter 24: Network Issues 13

Firm 1 choosing STRATEGIES similar to before. build a large installed base of the technology 2 and Technical Compatibility (cont. ) technology 1 and preferred technology with your name it; Firmon 21 and choosing assume there are two technologies, technology Firm. Again, 2 choosing technology but technology 2 is probably better and make sure that you have lined up suppliers 1 of technology is the technology 2 is 2, the complements so thatthe you arewant the one who Nash Equilibrium Tweedledum and Tweedledee, firms to differentiate Nash. In Equilibrium theirby products different strategies but each wants to be 1 gets to adopt that technology preferred by Firm preferred Firm 2 by choosing the one with the superior technology 2 Tweedledum and Tweedledee Firm 1 Technology 2 Technology 1 (3, 3) (6, 7) Technology 2 (8, 5) (2, 2) Firm 2 Chapter 24: Network Issues 14

If Firm 2 chooses technology Technical Compatibility (cont. ) 1 then There is no Nash Equilibrium If Firm 2 chooses 1 wants to What they really(in carepure about is differentiating their products by choosing strategies)—Firm 2 Firm may technology 2 then different technologies adopt technology 1, Firm 1 wants to frequently change or update toobrother) In Pesky Little Firm 2 is the its technology to dominant lose its firm (big use technology 2, Brother, that wants to limit competition from Firm 1 (little brother) by “little brother” as well adopting a different technology. Firm 1 always wants compatibility Pesky Little Brother Firm 1 Technology 2 Technology 1 (12, 4) (16, 2) Technology 2 (15, 2) (10, 5) Firm 2 Chapter 24: Network Issues 15

Systems Competition and Industry Standards • Public policy in the presence of strong networkk externalities is complicated • Low introductory pricing and bundling of complements may look like anticompetitive practices but are really just necessary to survive • Decreeing a common standard forces government to choose the winning standard. Governments are not necessarily good at picking winners • Should governments try to coordinate technology choices or, instead, “let a thousand flowers bloom” Chapter 24: Network Issues 16