Lecture Managerial economics - Chapter 8: Network effect

Week 8

Network Effect

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Motivation for Network Effect
AOL, Yahoo, MSN and Google offer free instant
messaging software.
• Clearly, not a profit maximizing strategy at
least in the short run.
• Why would they set price = $0 and maximize
the market share?

2


Network Externality
Network externality
• if the number of consumers using the product
increases the product’s demand
–similar to positive externality
–higher sales push demand curve out
• Examples?
– DVD players
– video game systems (PS2)
– Email
– Fax machine
–?
3

Source for Network Externalities?
need for a standard
• Same platform to exchange “data”
– MS Word software
– DVD players
– fax machines
– language
• industry standard for other products
– operating systems
– which side to drive on
– 110 voltage
If there’s a need for a standard, how many products (standards)
will survive?
4


Winner Takes All
How many products will survive in a market?
• Theoretically ONE, a natural monopoly
–empirically, more than 1 can survive because of different
consumer tastes
–but we expect 1 dominant product/standard
Implications of Network Externality for business strategy
• there might be a first-mover advantage
–a race for market share
–become the standard
–being the standard implies switching costs for your
customers

• justification for sacrificing short term profits in favor of long
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term profits.


Similar Rationale: Learning Curve
Learning Curve:
• Production cost gets lower over time b/c of experience
from producing.
Implications for business strategy?
• Lower price and produce more in the short run
–Sacrifice short run profit
• In long run, it can become the lowest cost provider
What is the difference between learning curve and NE?
• Learning curve : supply side effect, cost
• NE : demand side effect, standard
6


Lock-In
Suppose
• There are 2 products: I (inferior) and S (superior)
• There’s a significant network externality with these
products
If the inferior product entered the market first,
• It may become a monopoly.
• The superior product gets no market share.
• We are stuck with inferior product.
Outcome is not optimal for the society = Lock in

7


Examples of Lock-In (?)
Possible lock-ins (?)
• VHS v. BetaMax
• DOS v. Macintosh
• QWERTY v. Dvorak keyboards
• 110 voltage v. 220 voltage (?)
• Other example?
Lock-in is only a theoretical prediction
• Real evidence are hard to find
• The above examples are not conclusive evidence for
lock-ins.
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Entrant with the Superior Product
Attempt to unlock the Market
• The firm producing superior product will fight for the
market share
Conditions to unlock
• greater quality difference ⇒ easier to overcome
• many potential buyers ⇒ easier to increase market share
Business Strategy for the new entrant
• Product differentiation
• merger, if possible
• temporary price cuts
• further improvements in quality
• lower switching cost for existing customers

9


Business Strategy for the Incumbent
If you are incumbent with inferior product, what
is your business strategy?
• Given rival’s strategy, the only way to sustain the market
share is to improve the quality
• Invest in R&D
– Once invested, it will be sunk cost
– Once sunk, this cost will not affect future decision
– This is a leverage against new entry that must bear sunk
cost in future
• Lower price
– Doesn’t work well
10


Empirical Evidence for Lock-ins
Survival of the fittest
• If the new product is superior, it will prevail eventually
• The incumbent constantly improves its quality
Empirical Evidence
• Very hard to find a true example of lock-in
– The incumbent that survived must have some
advantage
• It may happen to standards related with custom, culture
– language (?)

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Unlocking Examples
Nintendo v. SONY PlayStation
Word Perfect v. MS Word
Quicken v. MS Money (?)
Other examples?
•?

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Summary
Network Externality
• Individual’s demand depends on others’ consumption.
Lock-In
• Conditions
– Significant network externality
– Inferior product was the first mover
• Result
– stuck with the inferior product
Empirical evidence
• History tells superior product eventually overtakes the
market
• Evidence for lock-in is rare
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Regulation, Public goods
Three categories of government's role in the economy:

1. Macroeconomic - Using fiscal (Congress) and monetary policy
(Federal Reserve) to achieve macroeconomic goals of stabilizing
the economy and promoting low unemployment, full output,
stable prices, stabilize the business cycles, prevent recessions,
etc.
2. Microeconomic - Provide public goods (national defense, FBI,
police protection, fire departments, roads and highways, court
system, patents, etc.) and regulate the economy (FDA, FTC,
DOJ, FAA, zoning, etc.)
3. Distributive - Redistribute income to reduce income
inequality, improve the welfare of the poor, provide medical care
(Medicare, Medicaid, VA hospitals), provide retirement income
(Social Security).
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The microeconomic role of Gov.
1) improve upon potential market failures,
inefficient production or consumption.
2) provide the "optimal" amount of public goods
and services that cannot be "provided" by the
private sector.

15


Market failures and regulation
Market Failure due to monopoly.
Government responses to monopoly practices (Enforce antitrust laws):
1> Breaking up monopoly. Examples: a> Standard Oil in 1911, 90%

market share for oil & b> AT&T in 1982 for 100% of the telephone
service.
2> Preventing Monopolies from Arising
3> Preventing Mergers that Reduce Competition. The government
blocked the mergers of: a> Staples and Office Depot & b> Rite-Aid
and Revco.
4> Preventing Collusion . a> Ivy League universities were forced to
stop meeting and sharing information on tuition increases, faculty
salaries and financial aid policies. b> Archer Daniels Midland
pleaded guilty to price fixing for food additives in the U.S. with
international competitors and it paid a $100m fine, the largest
antitrust fine in history.
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Market failures and regulation
Bottom line: Antitrust laws are complex, somewhat vague,
confusing and controversial
Controversy: "Chicago School" (laissez-faire) hands off
approach vs. pragmatic approach to antitrust enforcement.
Pragmatic Approach was more prevalent during Clinton's
administration, using more of a case-by-case approach.
E.g., the Office Depot-Staples merger was challenged even
though the combined firm would only have had 4% of the
national office supply market.

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Market failure due to externalities

Externalities (positive or negative) are secondary effects that have an
impact on the well-being of nonconsenting parties.
Pollution: negative externality (spillover cost). Literacy/Education:
positive externality (spillover benefit).
Solution: Government action could improve upon the market outcome
by: a) regulating the amount of pollution and b) requiring
mandatory attendance in school and providing public education.
Remedying Externalities
Solutions for externalities (negative) include: 1) government taxes,
standards or permits for externalities like pollution, or 2) monetary
payments between the affected parties by either bargaining
(negotiation) or by court decisions.
Transferable Emissions Permits is another regulatory approach.
Subsidizing Positive Externalities , Promoting R&D and Patent
system, and Regulatory Reform
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Market failure due to imperfect
information
In reality there could be many cases of incomplete, misleading
or inaccurate information about consumer products or
services, leading to a potential role for government
intervention to correct for market inefficiencies.
Example: Regulations for car companies including CAFE
(corporate average fuel economy) standards.
Benefit-cost analysis (BCA) is a method of making decisions
and evaluating public projects, programs, regulations,
etc. Any public decision can be guided by BCA.
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