Chapter 24: Network Issues1 Network Issues. Chapter 24: Network Issues2 Introduction Some products are popular with individual consumers precisely because

Chapter 24: Network Issues 1

Network Issues


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, e.g., Word on each other’s computers• More applications are written for 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


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

• Provider is a monopolist charging 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:

0 if fvi < p

1 if fvi pqi

D =


Monopoly Provision of a Network 2

• Consider the marginal consumer with basic valuation pfv ~

• The firm will serve all consumers with valuations v~

• Solving for the fraction f of the market served we have:

f = 1 - 100/~v = 1 – p/100f

• So, the inverse demand function is: p = 100f(1 – f)


Monopoly Provision of a Network 3• 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

0 0.2 0.4 0.6 0.8 1 f

25

20

15

10

5

0

$22.22

fL fH


Monopoly Provision of a Network 4

• 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


Monopoly Provision of a Network 5• 2. There are multiple equilibria

– At p < $25, there is more than one equilibrium value of f

– At p = $22.22 both fL(p) = 1/3 and fH(p) = 2/3 are possible f values

– 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 fH 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


Monopoly Provision of a Network 6– If the firm needs to serve more than one-third of

consumers at a price of $22.22, fL 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


Networks, Complementary Services & Competition 2• 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—Betamax versus VHS

or Blu-Ray versus AOD DVD format—either system may win

– Winning system is not necessarily the best one


Systems and Standards Competition

• 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?


Competition and Technical Compatibility

Firm 1

Old Technology

Old Technology

New Technology

(5,4) (2, 2)

(1, 5)

The fight over compatibility can lead to poor technical choices overall

New Technology

Firm 2

(6,7)

Excess Inertia

Two possible problems: Excess Inertia and Excess Momentum

Both staying

with the old technology is a Nash Equilibriu

m

Both switching to

the new technology is

a superior Nash

Equilibrium

Fear of being incompatible can lead to the inferior Nash Equilibrium—

neither firm switches because it thinks the other won’t switch


Technical Compatibility 2

Firm 1

Old Technology

Old Technology

New Technology

(6,7) (2, 2)

(1, 5)

In the case of excess inertia, each firm wants to adopt the same technology as its rival but, fearful that the rival won’t switch to the new technology, each wrongly stays with the old

New Technology

Firm 2

(5,4)

Excess Momentum

It is also possible that there is Excess Momentum and each wrongly switches to the New Technology

Both switching to the new technology is a Nash Equilibriu

m

Both staying with the old

technology is a superior

Nash Equilibrium

Again, fear of being incompatible can lead to the inferior Nash Equilibrium


Technical Compatibility 3• 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., PlayStation 3 vs. Wii vs. X-Box



Firm 1

Technology 1

Technology 1

Technology 2

(10,7) (6,5)

(5,4)

Assume there are two technologies, Firm 1’s technology 1 and Firm 2’s technology 2

Technology 2

Firm 2

(8,12)

Battle of the Sexes

In Battle of the Sexes firms still agree that there should be a common standard but each wants its own technology to be the standard

Firm 1 choosing technology 1 and Firm 2 choosing

technology 1 is the Nash Equilibrium

preferred by Firm 1



preferred by Firm 2

STRATEGIES:• build an early lead by establishing a large installed base; and 2) convince

the suppliers of complements to adopt your preferred technology



Firm 1

Technology 1

Technology 1

Technology 2

(3,3) (8,5)

(6,7)

Again, assume there are two technologies, technology 1 and technology 2, but technology 1 is probably better

Technology 2

Firm 2

(2,2)

Tweedledum and Tweedledee

In Tweedledum and Tweedledee, the firms want to differentiate their products by choosing different strategies but each wants to be the one with the superior technology 1



preferred by Firm 2



preferred by Firm 1

STRATEGIES similar to before.build a large installed base of the

preferred technology with your name on it; and make sure that you have lined up suppliers of

complements so that you are the one who gets to adopt that technology



Firm 1

Technology 1

Technology 1

Technology 2

(12,4) (16,2)

(15,2)

In Tweedledum and Tweedledee each firm wants superior technology but really care about differentiating their products by choosing different technologies

Technology 2

Firm 2

(10,5)

Pesky Little Brother

In Pesky Little Brother, Firm 1 is the dominant firm (big brother) that wants to limit competition from Firm 2 (little brother) by adopting a different technology. Firm 2 always wants compatibility

If Firm 1 chooses technology 2 then Firm 2 wants to

adopt technology 2, too

If Firm 1 chooses technology 1 then Firm 2 wants to

use technology 1, as well

There is no Nash Equilibrium (in pure strategies)—Firm 2 may frequently change or update

its technology to lose its “little brother”


Public Policy and Systems/Standards Competition• 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”


Empirical Application: Network Effects in Software—The Case of Spreadsheets

• Computer software is probably among those products with important network features, e.g., the more people that use Excel or PowerPoint the more usable and valuable they are to any one consumer

• Can we identify network features empirically?• A relatively early attempt is Gandal’s (1994) investigation

of spreadsheet program pricing


Empirical Application: Network Effects in Spreadsheet Programs 2

• A spreadsheet is a long-established business planning tool– Originally a pencil-and-paper operation with sheets organized into

many rows and columns that could be summed either vertically or horizontally to trace the impact of individual factors

– Computerized versions began to appear in 1980• By the mid-1980’s there were eight or more different

spreadsheet programs on the market– The dominant product was Lotus 1-2-3– Each product had different features, e.g.,

• Graphing• Ability to link entries in one spreadsheet to those in another• Lotus compatibility



• A hedonic regression is a model of price determination that explains a product price as a result of its key features rather than explicitly model supply and demand

• Gandal (1994) estimates an hedonic regression for spreadsheet progams over the years 1986 to 1991– Postulates key characteristics that should affect spreadsheet price– Identifies which characteriscs are network features– Explicitly considers the role of time and technical progress so that a

spreadsheet price index may be constructed



· Basic FeaturesLMINRC = a measure of sheer computing powerLOTUS = a 1,0 variable equal to 1 if it has the Lotus brandGRAPHS = a 1,0 variable equal to 1 if it has graphing abilityWINDOW = number of windows program handles simultaneouslyLINKING = a 1,0 variable equal to 1 if it links spreadsheet entries

Network FeaturesLOCOMP = a 1,0 variable equal to 1 if program is Lotus compatibleEXTDAT = a 1,0 variable equal to 1 if it can import external dataLANCOM = a 1,0 variable equal to 1 if it can link to a local network

Time Dummies one for each year to pick up the pure effect of time (technology improvement) on spreadsheet prices



Variable: Coefficient t-statistic LMINRC 0.11 ( 1.59)LOTUS 0.56 ( 4.36)GRAPHS 0.46 ( 3.51)WINDOW 0.17 ( 2.14)LINKING 0.21 ( 1.91)LOCOMP 0.72 ( 4.28)EXTDAT 0.55 ( 4.05)LANCOM 0.21 ( 1.65)CONSTANT 3.76 (12.31)1987 – 0.06 (–0.38)1988 – 0.44 (–2.67)1989 – 0.70 (–4.20)1990 – 0.79 (–4.90)1991 – 0.85 (–5.30)

Network features raise value of spreadsheet

program

Technical progress lowers

spreadsheet prices over time



• Gandal’s Results– Demonstrate importance of network features for spreadsheet

programs– Allow construction of a spreadsheet price index that controls

for quality, i.e., that reflects the pure passage of time– Since dependent variable is ln Price, Hedonic Price Index is:

ttYEARit ep

Implied Spreadsheet Price Index (1986 = 1.00) Year 1986 1987 1988 1989 1990 1991 Index 1.00 0.94 0.64 0.49 0.45 0.42

Documents

Chapter 24: Network Issues1 Network Issues. Chapter 24: Network Issues2 Introduction Some products are popular with individual consumers precisely because