4th Week

The network effect is the effect that the number of users or usage of a service has on the value of that service as perceived individually by each user

• Usage imposes a positive externality on other users

• Contrary to non-network goods, where consumption does not affect other

• Has strong implications for business strategy and competition

Examples: Multi-player online games, Telephony, email:, • GSM, UTMS, 5G, etc.

It is commonly assumed that networks’ value follows “Metcalfe’s law”:

• Total value is quadratic in the number of users 𝑛

• This is an urban myth, because most people interact mostly with a small number of family, friends, work contacts etc.

An alternative derived from statistical principles is Odlyzko-Tilly’s law: 𝑉~𝑛 ∗ ln 𝑛

• Network value grow is faster than linear, but much slower than quadratic

In many markets, network effects arise without users interacting directly

• Indirect network effects, usually intermediated by some “platform” through cross-platform externalities

  -> User group A (B) benefits from the presence of user group B (A)

Examples:

• Demand and supply of content for LP, VHS, DVD, HD-DVD/Blue-ray

• Players and developers on game platforms: PlayStation, Wii, Xbox, Nintendo

• Users and developers on operating systems: Windows, iOS, Android

The demand for network goods is very different from that of non-network goods

• depends on existing number of other users

• depends on expectations about future number of users -> particulary important is whether the network good is new to the market

This affects:

• shape of growth

• potential market outcomes

• Slow launch: few interactions possible

• Fast takeoff: network effects kick in!

• Slow-down: few non-users left to join

Each good or service needs to achieve a critical mass, i.e. number of customers

• Fixed and common cost needs to be covered by additional sales

• With network goods, the critical mass must be reached, i.e. the threshold where exponential growth takes off – more difficult to achieve

• If yes: Bandwagon / Domino / Snowball Effect

  • Stereo sound, VHS, QWERTY keyboard

• If no: shrinks back to zero

  • Quadrophonic sound, Betamax, DVORAK keyboard

Expectations and their management are essential for growth in network markets

-> expected net gain > price

Expectations tend to be self-fulfilling:

• Common commercial strategy is penetration pricing:

  -> initially low prices reach critical mass rapidly, then raise price

Assume incompatible networks: Users only derive utility from other users of the same network

How many networks will there be in equlibrium?

• Depends on preference for variety, and on strength of network effects

How is entry affected by network effects?

• network effecrs are hard to overcome

Ergodic System: long-run outcome does not depend on previous events

-> classical markets are ergodic, network markets not

Network markets are path-dependent:

• outcomes depend on history

• Small events may be enough to determine future of market, for example a small group of early adopters, or “random” fluctuations in the early market phase

• As time goes by, some firms grow a lot, and new competitors cannot catch up

Path-dependence: The strong become stronger, the weak become weaker

• Contrary to “classical” markets, the outcome tends to be extreme

• Add to this increasing returns to scale, i.e. declining average cost

• Reason for business strategy that invests heavily in growth, without profits in sight

How can several competitors persist?

• preference for variety stronger than network effect + return to scale

• Gen Z: does not want to be on their parents platfom

Absorbing barrier: number of users that makes market tip

Network effects drive the market structure towards huge quasi-monopolies

• Amazon, Google, Facebook

• Particularly likely if user groups single-home (“competitive bottleneck”)

Some platform markets have stable competition because groups multi-home:

-> Uber drivers also use Lyft and Bolt

Strategy to enter a platform market: divide-and-conquer

• give groups with high externalities subsidies to join the platform

• Charge the others later: cross-group subsidies

Late adoption/ Excess inertia:

Consumer 1 prefers N but keeps O because expects consumer 2 to keep O - consumer 2 does not switch, because consumer 1 didn’t

Early adoption (Excess momentum): consumer 1 prefers O but switches to N because expects consumer 2 to switch – consumer 2 switches because consumer 1 did

Should firms competing in network goods be compatible?

• Compatibility extends firm-level network effects to market-level effects

• This raises total surplus created, so good for society

• Firms will compete in the market, rather than for the market -> NE no longer differentiate, less liekly to become monopolist

• Firms choose compatibility unless they believe they can take over the market

• Compatibility is often imposed: interconnection of telecoms networks

Example: BluRay (Sony) vs HD-DVD (Toshiba)

Network externalities are strong barriers to entry

• Entrants must overcome critical mass, enough consumers must switch

• Problem: “Collective switching costs”: switching not individually optimal unless others

• Compatibility helps to gain customers, therefore incumbents not interested (MS vs Netscape)

Office 365 can read .doc files (from 1990s)

-> allows MS to interact with legacy users and sell new product to them

Entrants also use this trategy:

• One-sided compatibility allows customers of entrant to “interconnect” with incumbent user base

• Incumbent may tolerate this, or try to sabotage this -> Nescafé machines not working with copycats capsules anymore

There are benefits from standardization: larger network externalities, Should governments intervene?

Problems:

• Why should government know which technology brings most future benefits? Competition selects technologies, and brings more choice and lower prices

• Decision process creates uncertainty and delays -- this can kill a new technology

• Attempts to create national champions distort and segment market outcomes -> HDTV standard battle(USA, Jaoan, Europe)

• Network effects are important: create a cycle of positive feedback

• Consumer expectations are essential

• Diffusion follows an S-curve, once a critical mass has been reached

• These effects are particularly strong in digital markets

• Compatibility or interoperability with rivals

• Compatibility with legacy products

• Open or closed standards (Android or iOS)

• Candidates: Markets with at least two interacting groups (e.g. buyers/sellers)

• One or more “platforms” through which interaction takes place

• Payments to platform: Membership, usage, or “free”

• Attention: The distribution of payments may matter

  (holding the sum constant)

Examples two sided platforms: Trading, Credit card, Real estate, Dating Apps, Transport, travel

• Multisided platforms exist to create and amplify cross-platform externalities

• The presence of a group benefits the other

• Need not be symmetric: Eyeballs positive for advertisers, but advertisers (mostly) negative for eyeballs

Within-group externalities also exist:

• Direct: negative between sellers because of competition

• Indirect: positive between sellers because more sellers attract more customers

Spotify

• Subscribers

• “Free” viewers

• Content sellers

• Advertisers

Platform prices are often very skewed:

• One side pays very little or zero, but the other side is charged heavily

  • Payment cards: user pays zero per transaction, high merchant charge (antitrust complaints have been ongoing for more than 20 years!)

  • Videogame platforms: consoles often sold without profit, but royalties high

Why is platform pricing so lopsided?

• Platform needs to get enough members of both groups to join! -> coordination problem (linkage)

Subsidize the side that is harder to capture

• the side that has the option for multi homing

• Absence of relationship-specific investments:

• In one-sided markets, “price below marginal cost” is considered anti-competitive: predation or dumping (in Portugal forbidden by law)

• In two-sided markets, it can be efficient: get the right people on the platform

• Equally, in one-sided markets, “excessive prices” are an abuse of dominance

• In two-sided markets, can be part of an efficient pricing structure, financing a subsidy

Standard procedure in competition cases (abuses, mergers, etc.):

• 1. Market Definition

• 2. Find dominance or not

• 3. Remedies

-> Defining the “relevant market” is unclear because platforms serve multiple interlinked sides

Aim: protection of consumers, businesses, and legal certainty for platforms

• Hierarchy of “intermediary services, hosting services, online platforms, very large platforms & search engines

Obligations:

• Transparency

• Cooperation with authorities, local

  representatives

• Security and safety measures

• Security and safety measures

• Data sharing with authorities and

  researchers!