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Slides Industrial Organization: Markets and Strategies Paul Belleflamme and Martin Peitz © Cambridge University Press 2009 Networks, standards and systems.

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Presentation on theme: "Slides Industrial Organization: Markets and Strategies Paul Belleflamme and Martin Peitz © Cambridge University Press 2009 Networks, standards and systems."— Presentation transcript:

1 Slides Industrial Organization: Markets and Strategies Paul Belleflamme and Martin Peitz © Cambridge University Press 2009 Networks, standards and systems Part VIII. Networks, standards and systems Markets with network goods Chapter 20. Markets with network goods

2 © Cambridge University Press Introduction to Part VIII Peculiarities of the information economy Choosing between and or between and What are the differences? Instant messaging software Potatoes Care about previous choices?YESNO Care about future choices?YESNO Care about other peoples choices? * other consumers of the good * producers of complementary goods YES NO Chain of complementary products systems Network goods

3 © Cambridge University Press Introduction to Part VIII Organization of Part VIII Chapter 20 Chapter 20 Demand side of network goods Network effects several demand levels compatible with the same price Provision of a single network good Choice between incompatible network goods Chapter 21 Chapter 21 Supply side of network goods Specific strategic instruments Compatibility or incompatibility? Timing of entry Managing consumers expectations Public policy in network markets

4 © Cambridge University Press Objectives Chapter 20 - Objectives Learning objectives Chapter 20. Learning objectives Understand what network effects are. Direct and indirect network effects Compare network effects to switching costs. Empirical estimation of network effects Analyze demand and supply of network goods. Single good / Several incompatible goods Demand decisions may lead to multiple equilibria. Supply decisions crucially depend on the level of compatibility between competing goods. Learning objectives Chapter 20. Learning objectives Understand what network effects are. Direct and indirect network effects Compare network effects to switching costs. Empirical estimation of network effects Analyze demand and supply of network goods. Single good / Several incompatible goods Demand decisions may lead to multiple equilibria. Supply decisions crucially depend on the level of compatibility between competing goods.

5 © Cambridge University Press Network effects Basic idea Other things being equal, it's better to be connected to a bigger network. More precisely A product exhibits network effects if each user's payoff is increasing in the number of other users of that product or of products compatible with it. Observed in 2 types of markets Network (or communication) markets Network (or communication) markets The benefit of consumers comes from the ability to communicate with other consumers via the network. Direct network effectsDirect network effects: more agents in the network more communication opportunities more incentives to join the network Examples: phone, fax, , instant messaging, languages Network effects Chapter 20 - Network effects

6 © Cambridge University Press Network effects (contd) Observed in 2 types of markets (contd) System markets System markets Products are obtained by combining components in a complementary way (e.g., hardware + software). Indirect network effectsIndirect network effects: more users of the system more developers desire to write application for the system more incentives for users to buy the system. Special case: two-sided markets (see Chapter 22) Examples: videogame consoles, CD and DVD players Network effects (NE) and switching costs (SC) Meaning of compatibility Meaning of compatibility SC. Consumer values compatibility between his/her purchases (ability to take advantage of the same investment). NE. Consumer values compatibility with other consumers' purchases ( ability to communicate or to take advantage of the same complements). Network effects Chapter 20 - Network effects

7 © Cambridge University Press Network effects (contd) NE and SC (contd) Competition vs. contracts Competition vs. contracts SC. Competition focuses on streams of products or services, while contracts often cover only the present. NE. Competition concerns selling to large groups of users, while contracts usually cover only a bilateral transaction between one seller and one user. SC and NE. Incomplete contracts potential market failures Expectations play a key role Expectations play a key role Contracts fail to specify complementary transactions buyers' expectations about them are crucial. History matters History matters Consumers: past adoptions guide future adoptions Firms: past market share is a valuable asset Network effects Chapter 20 - Network effects

8 © Cambridge University Press Case. Case. Network effects or switching costs? Network effects switching costs Network effects switching costs When groups of users make sequential choices, early choices tend to commit later users collective switching costs Switching costs network effects Switching costs network effects When choosing between competing systems, consumers tend to privilege the one offering the largest (current and future) availability of applications. This availability depends on the number of consumers who adopt the system in question only if there are switching costs between systems, both for consumers and for application writers. These switching costs are related to the degree of compatibility between systems. Case. Case. Network effects or switching costs? Network effects switching costs Network effects switching costs When groups of users make sequential choices, early choices tend to commit later users collective switching costs Switching costs network effects Switching costs network effects When choosing between competing systems, consumers tend to privilege the one offering the largest (current and future) availability of applications. This availability depends on the number of consumers who adopt the system in question only if there are switching costs between systems, both for consumers and for application writers. These switching costs are related to the degree of compatibility between systems. Network effects Chapter 20 - Network effects

9 © Cambridge University Press Network effects (contd) Empirical evidence Theoretical prediction Theoretical prediction Value of network good with size of associated network How to test it? How to test it? Include demand for the good as a predictor of itself? Fraught with difficulty Positive coefficient could be the result of network effects, but also of correlations with unobserved taste or quality variables, or of herding and learning effects. Hedonic price approachHedonic price approach Estimate implicit price of having either an installed base, or compatible products, or an established standard. Nested logit approachNested logit approach Indirect network effects are characterized by the interaction between consumers hardware choice and software producers supply decisions. Network effects Chapter 20 - Network effects

10 © Cambridge University Press Modelling the demand for a network good Typical utility function Markets for a single network good Chapter 20 - Markets for a single network good Stand-alone benefitNetwork benefit

11 © Cambridge University Press Modelling the demand for a network good (contd) direct network effects Well suited to describe direct network effects Markets for a single network good Chapter 20 - Markets for a single network good Local telephone exchange User A accesses the network by purchasing a link from her location to the local switch (link AS). If consumer B has subscribed to a similar link (link BS), A and B are able to call each other. Links AS and BS = 2 complementary goods creating a valuable system. n subscribers n n systems ( n ) th subscriber creates n new systems, which benefits all existing subscribers direct network effect S A B C DE F G

12 © Cambridge University Press Modelling the demand for a network good (contd) reduced form for indirect network effects Also, reduced form for indirect network effects Consumer's utility for a particular hardware with number of compatible applications available for this hardware, m j U ij = g i (m j ) But, number of compatible applications with (expected) number of consumers who adopt the hardware m j = h(n j e ) To recover the initial formulation, write f i (n j e ) = g i ( h(n j e ) ) Potential interdependences EntryEntry For given quality levels, sellers have to decide whether to enter. If sellers offer distinct products, the more sellers the more variety. Entry decision depends on number of active users. Users utility with variety. Markets for a single network good Chapter 20 - Markets for a single network good

13 © Cambridge University Press Modelling the demand for a network good (contd) Reduced form for indirect network effects Reduced form for indirect network effects Potential interdependences (contd) QualityQuality Seller investment in quality is affected by active number of buyers Users utility with product quality. Simple model: videogame console n consumers; utility with quality of games, s Quality s with developpers investement, x : Marginal cost of increasing quality = 1 Division of benefits for each transaction: share for developper and share for consumer Developpers problem: Consumers utility: Markets for a single network good Chapter 20 - Markets for a single network good

14 © Cambridge University Press Modelling the demand for a network good (contd) Modelling expectations Modelling expectations Fulfilled expectations Fulfilled expectations Consumers base their current purchasing decisions on their expectations about future network sizes. Attention is restricted on equilibria in which these expectations turn out to be correct (i.e., are rational). Myopic expectations Myopic expectations Consumers base their decisions only on actual network sizes. Markets for a single network good Chapter 20 - Markets for a single network good Lesson: Indirect network effects can arise in a buyer– seller context because of the effect of consumer participation (and intensity of use) on quality, price and variety. In the reduced form consumer utility directly depends on the number of consumers.

15 © Cambridge University Press Modelling the demand for a network good (contd) Modelling consumers heterogeneity Modelling consumers heterogeneity Simplifications Unique network (drop subscript j ) Mass 1 of consumers identified by taste parameter Linear network effects 2 scenarios Heterogeneous network effectsHeterogeneous network effects Heterogeneous stand-alone benefitsHeterogeneous stand-alone benefits Markets for a single network good Chapter 20 - Markets for a single network good

16 © Cambridge University Press Case. Case. Heterogeneous adopters for network goods Consumer electronics products Characterized by sequential adoption Minority of early adopters high Why are early adopters keener to adopt the new network good? Value more network benefits or stand-alone benefits? Blackberry Blackberry heterogeneous network benefits Early adopters = business people value highly the possibility of reading and sending s any time & anywhere heterogeneous network benefits High-definition television High-definition television heterogeneous stand-alone benefits Early adopters = tech aficionados primarily interested in superior picture quality heterogeneous stand-alone benefits Case. Case. Heterogeneous adopters for network goods Consumer electronics products Characterized by sequential adoption Minority of early adopters high Why are early adopters keener to adopt the new network good? Value more network benefits or stand-alone benefits? Blackberry Blackberry heterogeneous network benefits Early adopters = business people value highly the possibility of reading and sending s any time & anywhere heterogeneous network benefits High-definition television High-definition television heterogeneous stand-alone benefits Early adopters = tech aficionados primarily interested in superior picture quality heterogeneous stand-alone benefits Markets for a single network good Chapter 20 - Markets for a single network good

17 © Cambridge University Press Network effects and equilibrium network size Heterogeneous network effects Heterogeneous network effects Suppose price of network good is p Indifferent consumer All consumers with higher valuation buy. So: Fulfilled expectations, n n e : Markets for a single network good Chapter 20 - Markets for a single network good

18 © Cambridge University Press Network effects and equilibrium network size (contd) Heterogeneous network effects Heterogeneous network effects (contd) Markets for a single network good Chapter 20 - Markets for a single network good D i = p(n,n i ) willingness to pay for a varying quantity n, given an expected network size n e n i At n n i, expectations are fulfilled and the point belongs to p(n,n).

19 © Cambridge University Press Network effects and equilibrium network size (contd) Heterogeneous network effects Heterogeneous network effects (contd) There might exist more than one n (that is, more than one quantity or network size) that satisfies the equilibrium condition for a given price. Markets for a single network good Chapter 20 - Markets for a single network good n p a n2(p)n2(p) n1(p)n1(p) 1

20 © Cambridge University Press Network effects and equilibrium network size (contd) Heterogeneous network effects Heterogeneous network effects (contd) 3 self-fulfilling prophecies! 3 self-fulfilling prophecies! No buyer buy: n If pessimistic expectations ( n e ), no buyer buys at p > a. A small number, n 1 (p), of buyers buy. Expected small n small valuation good is bought only by buyers with large. A large number, n 2 (p), of buyers buy. Expected large n large valuation good is bought by a large number of buyers, but the last buyer has a small. Markets for a single network good Chapter 20 - Markets for a single network good Lesson: Due to network effects that affect consumers utility differently, there often exist multiple consumer equilibria for the given price of the network industry.

21 © Cambridge University Press Network effects and equilibrium network size (contd) Heterogeneous network effects Heterogeneous network effects (contd) Equilibrium selection Dynamic adjustment process: if willingness to pay > (<) price, then n increases (decreases) Markets for a single network good Chapter 20 - Markets for a single network good n p a n2(p)n2(p) n1(p)n1(p) 1 Unstable Stable Pareto dominates Critical mass

22 © Cambridge University Press Network effects and equilibrium network size (contd) Heterogeneous stand-alone benefits Heterogeneous stand-alone benefits Markets for a single network good Chapter 20 - Markets for a single network good The fulfilled expectations demand is monotone and strictly decreasing if network effects are not too strong. If network effects are sufficiently strong, there might exist multiple consumer equilibria for the given price of the network industry.

23 © Cambridge University Press Provision of a network good Assumptions A single network good is available. Consumers expectations are fulfilled at equilibrium. Selection of Pareto-dominant equilibrium (if multiplicity) Constant marginal cost of production: c Supply decision Perfect competition vs. Monopoly Comparison with social optimum Are network effects a source of externalities? See details in book. Markets for a single network good Chapter 20 - Markets for a single network good

24 © Cambridge University Press Provision of a network good (contd) Perfect competition vs. monopoly Perfect competition vs. monopoly Markets for a single network good Chapter 20 - Markets for a single network good Lesson: A monopolist (who cannot resort to price discrimination) supports a smaller network and charges a higher price then perfectly competitive firms.

25 © Cambridge University Press Provision of a network good (contd) Comparison with social optimum Comparison with social optimum Social welfare is maximized when all consumers join the network ( n ) underprovision by the market network externalities Sources of market failure Sources of market failure Consumers fail to internalize that other consumers are also made better off by their decision to join the network. If large enough production cost, neither a monopolist nor competitive firms manage to internalize these external effects. Markets for a single network good Chapter 20 - Markets for a single network good Lesson: There is a tendency towards underprovision of the network good by the monopolist, and even by perfectly competitive firms.

26 © Cambridge University Press Markets for several network goods Consumers may have to choose between several competing network goods. Relevant if network goods are incompatible. 2 approaches Consumers coordination efforts Consumers coordination efforts Consumers try to coordinate their actions to make their choices compatible. Simplifying assumptions: 2 competitively supplied goods Firms compatibility decisions Firms compatibility decisions Firms may decide to provide some degree of compatibility between their products. Simplifying assumptions: Cournot duopoly Markets for several network goods Chapter 20 - Markets for several network goods

27 © Cambridge University Press Demand for incompatible network goods Main results Main results Coordination problems among consumers Potential market failures Dominance of the market by the wrong technology Excess inertia or excess momentum More likely under incomplete information Sequential choices: self-reinforcement and lock-in Sequential choices: self-reinforcement and lock-in Model 2 goods exhibiting network effects: A and B Heterogeneous stand-alone benefits A -fans derive larger benefits from A than from B B -fans derive larger benefits from B than from A Equally represented in the population Myopic expectations Markets for several network goods Chapter 20 - Markets for several network goods

28 © Cambridge University Press Demand for incompatible network goods (contd) Sequential choices Sequential choices (contd) Consumers utility Timing Consumers arrive in the market sequentially. At each period t, a consumer (a A -fan or a B -fan with equal probability) decides to adopt good A or good B We look at the sequence Markets for several network goods Chapter 20 - Markets for several network goods Numbers of consumers having adopted goods A and B at date t A B B A

29 © Cambridge University Press Demand for incompatible network goods (contd) Sequential choices Sequential choices (contd) Evolution of t No network effect ( ) "random walk", the difference eventually tends to zero (ahistorical process) Network effects ( ) "random walk with absorbing barriers (ergodic process) Markets for several network goods Chapter 20 - Markets for several network goods ABSORBING BARRIERS t A all subsequent consumers adopt B t B all subsequent consumers adopt A

30 © Cambridge University Press Demand for incompatible network goods (contd) Sequential choices Sequential choices (contd) Markets for several network goods Chapter 20 - Markets for several network goods Both consumer types adopt A (lock-in to A ) Both consumer types adopt B (lock-in to B ) Each consumer type adopts its preferred good A leads B leads

31 © Cambridge University Press Demand for incompatible network goods (contd) Sequential choices Sequential choices (contd) Competition between incompatible goods: properties Path-dependencePath-dependence outcome depends on the way in which adoptions build up (i.e., on the path the process takes). Inflexibilitylock-inInflexibility, or lock-in the left-behind good would need to bridge a widening gap if it is chosen by adopters at all. Non predictabilityNon predictability the process locks in to monopoly of one of the 2 goods, but which good is not predictable in advance. Potential inefficiencyPotential inefficiency the good that takes the market needs not be the one with the longer-term higher payoff. Markets for several network goods Chapter 20 - Markets for several network goods Lesson: The competition between incompatible network goods is likely to lead, in the long run, to market dominance by a single good. The dominant good cannot be predicted beforehand and might not be the best available option.

32 © Cambridge University Press Demand for incompatible network goods (contd) Excess inertia & momentum, and bandwagons Excess inertia & momentum, and bandwagons Model 2 strategic consumers, simultaneous decisions 2 network goods: A (old good) and B (new good) Network effects: A, B Larger stand-alone benefit for new good: a B a A Game typical coordination game Markets for several network goods Chapter 20 - Markets for several network goods

33 © Cambridge University Press Demand for incompatible network goods (contd) Excess inertia & momentum, and bandwagons Excess inertia & momentum, and bandwagons Nash equilibrium Markets for several network goods Chapter 20 - Markets for several network goods A B EXCESS MOMENTUM if B is adopted EXCESS INERTIA if A is adopted

34 © Cambridge University Press Demand for incompatible network goods (contd) Excess inertia & momentum, and bandwagons Excess inertia & momentum, and bandwagons complete information If complete information about other users preferences Coordination failures are an artifact of simultaneous decisions (if sequential choices users coordinate on Pareto- dominating good). incomplete information If incomplete information, real possibility of excess inertia and excess momentum typical situation: You would enjoy the largest benefits if you and the other user switched to the new good. But you dont know the other users payoff and there is thus a chance that you would not be followed in the case you initiated the switch. As you fear the low benefits you would earn in that case, you are not willing to take the risk of moving first. Now, if the other user is just like you, both of you will wait and no one will switch, therefore failing to achieve high benefits. Markets for several network goods Chapter 20 - Markets for several network goods

35 © Cambridge University Press Demand for incompatible network goods (contd) Excess inertia & momentum, and bandwagons Excess inertia & momentum, and bandwagons Model with incomplete information See details in book. Illustration of Bandwagon equilibrium Markets for several network goods Chapter 20 - Markets for several network goods Lesson: There is excess inertia when users fail to switch to a new network good although they would be made better off if every user switched. Excess inertia is more likely to happen in markets with indirect rather than direct network effects and where each user only has incomplete rather than full information about the other users preferences (which might conflict with hers).

36 © Cambridge University Press Case. Case. Failure of quadraphonic sound Early 1970s Quadraphonic sound introduced as alternative to stereophonic sound for playing audio recordings. Higher quality but it didnt become the new industry standard. Why did the initial support quickly fade? Early adopters were dissatisfied. Several incompatible formats coexisted. Uncertainty about which version would prevail. Similar stories Digital cassettes Digital videos Different versions of teletext Case. Case. Failure of quadraphonic sound Early 1970s Quadraphonic sound introduced as alternative to stereophonic sound for playing audio recordings. Higher quality but it didnt become the new industry standard. Why did the initial support quickly fade? Early adopters were dissatisfied. Several incompatible formats coexisted. Uncertainty about which version would prevail. Similar stories Digital cassettes Digital videos Different versions of teletext Markets for several network goods Chapter 20 - Markets for several network goods

37 © Cambridge University Press Markets for several network goods (contd) Oligopoly pricing and standardization Oligopoly pricing and standardization nature of competition The degree of compatibility between 2 goods determines the nature of competition between the firms sponsoring these goods. competition FOR the market Incompatible goods one good eventually dominates (see previous analysis) competition FOR the market competition IN the market Compatible goods single network several goods may coexist competition IN the market Firms can make goods compatible through standardization. Markets for several network goods Chapter 20 - Markets for several network goods

38 © Cambridge University Press Markets for several network goods (contd) Katz-Shapiro model Katz-Shapiro model 2 network goods, heterogeneous stand-alone benefits Surplus for new consumer of type when purchasing good of firm i at price p i where g i relevant expected network benefit from good i Markets for several network goods Chapter 20 - Markets for several network goods Expected numbers of new consumers Level of compatibility between the 2 goods, Installed bases Past locked-in consumers Strength of network effects Assumption: <1/2

39 © Cambridge University Press Markets for several network goods (contd) Katz-Shapiro model Katz-Shapiro model (contd) Firms compete à la Cournot over new customers They choose capacities for market expansion simultaneously. Given these capacities, prices adjust at levels such that consumers are indifferent between the 2 goods, and demand is equal to supply. If goods A and B attract new consumers, quality- adjusted prices are the same: Indifferent consumer is such that Markets for several network goods Chapter 20 - Markets for several network goods

40 © Cambridge University Press Markets for several network goods (contd) Katz-Shapiro model Katz-Shapiro model (contd) Uniform distribution of + fulfilled expectations Firm i chooses q i to maximize i (p i (q i,q j ) c i ) q i Nash equilibrium Markets for several network goods Chapter 20 - Markets for several network goods

41 © Cambridge University Press Markets for several network goods (contd) Katz-Shapiro model Katz-Shapiro model (contd) Comparative static results - 1 Markets for several network goods Chapter 20 - Markets for several network goods Lesson: In a market with network effects and two competing networks, enhanced compatibility leads to a market expansion effect, resulting in a larger consumer surplus.

42 © Cambridge University Press Markets for several network goods (contd) Katz-Shapiro model Katz-Shapiro model (contd) Comparative static results - 2 Markets for several network goods Chapter 20 - Markets for several network goods Lesson: Enhanced compatibility reduces quality differentiation. Thus enhanced compatibility is less attractive for a firm that is more efficient or enjoys a larger installed base.

43 © Cambridge University Press Case. Case. Lego - a wall to protect the bricks? Toy bricks = network good The more compatible bricks you and your friends have, the larger your building possibilities. Intellectual Property protection of Lego bricks Last patents expired in 1978 Since then, the LEGO Group has zealously guarded its trademarks and other IP rights. Dozens of lawsuits against competitors 2005: LEGO failed in its attempt to enforce its trademark for the design of its bricks in the Canadian Supreme Court: The monopoly on the bricks is over, and Mega Bloks and Lego bricks may be interchangeable in the bins of the playrooms of the nation. Dragons, castles and knights may be designed with them, without any distinction. Case. Case. Lego - a wall to protect the bricks? Toy bricks = network good The more compatible bricks you and your friends have, the larger your building possibilities. Intellectual Property protection of Lego bricks Last patents expired in 1978 Since then, the LEGO Group has zealously guarded its trademarks and other IP rights. Dozens of lawsuits against competitors 2005: LEGO failed in its attempt to enforce its trademark for the design of its bricks in the Canadian Supreme Court: The monopoly on the bricks is over, and Mega Bloks and Lego bricks may be interchangeable in the bins of the playrooms of the nation. Dragons, castles and knights may be designed with them, without any distinction. Markets for several network goods Chapter 20 - Markets for several network goods

44 © Cambridge University Press Review questions Chapter 20 - Review questions Review questions Define direct and indirect network effects, and illustrate with examples. Explain why there often exist multiple consumer equilibria for a given price of the network industry. Explain why there is a tendency towards underprovision of a network good by a monopolist, and even by perfectly competitive firms. Explain why the competition between incompatible network goods is likely to lead, in the long run, to market dominance by a single good. Review questions Define direct and indirect network effects, and illustrate with examples. Explain why there often exist multiple consumer equilibria for a given price of the network industry. Explain why there is a tendency towards underprovision of a network good by a monopolist, and even by perfectly competitive firms. Explain why the competition between incompatible network goods is likely to lead, in the long run, to market dominance by a single good.

45 © Cambridge University Press Review questions Chapter 20 - Review questions Review questions (contd) Describe what is meant by excess inertia and explain why this situation is more likely to happen in markets with indirect rather than direct network effects and where each user only has incomplete rather than full information about the other users preferences. Review questions (contd) Describe what is meant by excess inertia and explain why this situation is more likely to happen in markets with indirect rather than direct network effects and where each user only has incomplete rather than full information about the other users preferences.


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