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  • 8/9/2019 [Economides] the Economics of Networks

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    ELSEVIER

    International Journal of Industrial Organization

    14 (1996) 673-699

    n t m t i ~ l Jo u rn a lo f

    I n d u s t r i a l

    O r g a n i z a d o n

    T h e E c o n o m i c s o f n e tw o r k s

    Nicholas conomides

    Stern School of Business New York University New York NY 10012-1126 USA

    A b s t r a c t

    I a n a l y z e t h e s a l i e n t f e a t u r e s o f n e t w o r k s a n d p o i n t o u t t h e s i m i l a r i t i e s b e t w e e n t h e

    e c o n o m i c s t r u c tu r e o f n e t w o r k s a n d t h e s t r u c tu r e o f v e r t ic a l l y re l a t e d in d u s t ri e s . T h e

    a n a l y s i s f o c u s e s o n p o s i t i v e c o n s u m p t i o n a n d p r o d u c t i o n e x t e r n a l i t i e s , c o m m o n l y c a l l e d

    n e t w o r k e x t e r n a l i t i e s . I d i s c u s s t h e i r s o u r c e s a n d t h e i r e f f e c t s o n p r i c i n g a n d m a r k e t

    s t r u c t u r e . I d i s t i n g u i s h b e t w e e n r e s u l t s t h a t d o n o t d e p e n d o n t h e u n d e r l y i n g i n d u s t r y

    m i c r o s t r u c t u r e ( t h e ' m a c r o ' a p p r o a c h ) a n d t h o s e t h a t d o ( t h e ' m i c r o ' a p p r o a c h ) . I a n a l y z e

    t h e i s s u e s o f c o m p a t i b i li t y , c o o r d i n a t i o n t o t e c h n i c a l s t a n d a rd s , i n t e r c o n n e c t i o n a n d

    i n t e r o p e r a b i l i t y , a n d t h e i r e f f e c t s o n p r i c i n g a n d q u a l i t y o f s e r v i c e s a n d o n t h e v a l u e o f

    n e t w o r k l i n k s in v a r i o u s o w n e r s h i p s t ru c t u re s . I a l s o b r ie f l y d is c u s s t h e i s s u e o f i n t e r c o n n e c -

    t i o n f ee s fo r b o t t l en eck f ac i l i t i e s .

    I I n t r o d u c t i o n 2

    N e t w o r k i n d us t ri e s p la y a c r u c ia l r o l e i n m o d e m l if e . T h e m o d e m e c o n o m y

    w o u l d b e v e r y m u c h d i m i n i s h e d w i t h o u t th e tr a n sp o r ta t io n , c o m m u n i c a t i o n s ,

    i n f o r m a t i o n , a n d r a i l r o a d n e t w o r k s . T h i s e s s a y w i l l a n a l y z e th e m a j o r e c o n o m i c

    f e a t u r e s o f n e t w o r k s . I n t h e c o u r s e o f t h e a n a l y s is i t w i l l b e c o m e c l e a r t h a t m a n y

    i m p o r t a n t n o n - n e t w o r k i n d u st r i e s s h a r e m a n y e s s e n t ia l e c o n o m i c f e a tu r e s w i t h

    n e t w o r k i n d u s tr i e s . T h e s e n o n - n e t w o r k i n d u s t r i e s a re c h a r a c t e r i z e d b y s tr o n g

    c o m p l e m e n t a r y r e l a t i o n s . T h u s , t h e l e s so n s o f n e t w o r k s c a n b e a p p l i e d to

    ]Plenary session address, E.A.R.I.E. conference, Chan ia, Greece, September 1994. I thank Larry

    White for helpful comments.

    2The literature on netwo rks is so extensive that it is futile to attempt to co ve r it . This paper discusses

    only some issues that arise in networks and attempts to point out areas in which further research is

    necessary.

    0167-7187/96/ 15.00 © 199 6 Elsevier Science B.V. All rights reserved

    PII

    S 0 1 6 7 - 7 1 8 7 ( 9 6 ) 0 1 0 1 5 - 6

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    674

    N. Economides / Int. J. Ind . Or gan . 14 1996) 673 -69 9

    industries where vertical relations play a crucial role; conversely, the economic

    and legal learning developed in the analysis of vertically related industries can be

    applied to network industries.

    2 C l a s s if i ca t io n o f n e t w o r k s

    Formally, networks are composed of links that connect nodes. It is inherent in

    the structure of a network that many components of a network are required for the

    provision of a typical service. Thus, network components are complementary to

    each other. Fig. 1 represents the emerging

    i n f o r m a t i o n s u p e r h i g h w a y

    network.

    Clearly, services demanded by consumers are composed of many complementary

    components. For example, interactive ordering while browsing in a department

    store as it appears in successive video frames requires a number of components: a

    database engine at the service provider, transmission of signals, decoding through

    an interface, display on a TV or computer monitor, etc. Clearly, there are close

    substitutes for each of these components; for example, transmission can be done

    through a cable TV line, a fixed telephone line, a wireless satellite, PCN, etc.; the

    in-home interface may be a TV-top box or an add-on to a PC, etc. It is likely that

    the combinations of various components will not result in identical services. Thus,

    the information superhighway will provide substitutes made of complements; this

    is a typical feature of networks.

    Fig. 2 shows this feature in a simple star telephone network. A phone call from

    A to B is composed of

    A S

    (access to the switch of customer

    A ) , B S

    (access to the

    D IRECT

    BROADCAST

    CABLE

    SATELLITE

    W IRELESS )

    TELCO

    Fig. 1. An information superhighway.

    PERSONAL

    COMMUN .

    SERV ICES

    PCS ,PCN

    W IRELESS )

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    N. Economides / Int. J . Ind. Organ. 14 199 6) 67 3- 69 9 675

    B

    F o

    Fig. 2. A :simple star netwo rk.

    s w i t c h o f c u s t o m e r B ) , a n d s w i t c h i n g s e r v i c e s a t S . D e s p i t e t h e fa c t th a t g o o d s

    A S

    a n d B S l o o k v e r y s i m i l a r a n d h a v e t h e s a m e i n d u s t r i a l c l a s s i f ic a t i o n , t h e y a r e

    c o m p l e m e n t s a n d n o t s u b s t i t u t e s .3

    N e t w o r k s w h e r e s e r v i c e s

    A B

    a n d

    B A a r e

    d i s ti n c t a r e n a m e d t w o - w a y n e t w o r k s

    i n E c o n o m i d e s a n d W h i t e ( 1 9 9 4 ). T w o - w a y n e t w o r k s i n c l u d e r a i lr o a d , r o a d , a n d

    m a n y t e l e c o m m u n i c a t i o n s n e tw o r k s . W h e n o n e o f A B o r B A i s u n f e a s i b le , o r d o e s

    n o t m a k e e c o n o m i c s e n s e , o r w h e n t h e r e is n o s e n s e o f d i r e c t i o n in th e n e t w o r k s o

    t h a t

    A B

    a n d

    B A a r e

    i d e n t i c a l , t h e n t h e n e t w o r k i s c a l l e d a o n e - w a y n e t w o r k . I n a

    t y p i c a l o n e - w a y n e t w o r k , t h e re a r e tw o t y p e s o f c o m p o n e n t s , a n d c o m p o s i t e g o o d s

    a r e f o r m e d o n l y b y c o m b i n i n g a c o m p o n e n t o f e a c h t y p e , a n d c u s t o m e r s a r e o f t e n

    n o t id e n t i fi e d w i t h c o m p o n e n t s b u t i n s te a d d e m a n d c o m p o s i t e g o o d s . F o r e x a m p l e ,

    b r o a d c a s t i n g a n d p a g i n g a r e o n e - w a y n e t w o r k s 4

    T h e c l a s s i f i c a t i o n i n n e t w o r k t y p e ( o n e - w a y o r t w o - w a y ) i s n o t a f u n c t i o n o f th e

    t o p o l o g i c a l s t r u c tu r e o f t h e n e t w o r k . R a t h e r , i t d e p e n d s o n t h e i n t e r p r e t a t i o n o f th e

    s t r u c tu r e t o r e p r e s e n t a s p e c i f i c se r v i c e . F o r e x a m p l e , t h e n e t w o r k o f F i g . 3 c a n b e

    i n t e r p r e t e d a s a t w o - w a y t e l e p h o n e n e t w o r k w h e r e S A r e p r e s e n t s a l o c a l s w i t c h i n

    c i t y A , A i r e p r e s e n t s a c u s t o m e r i n c i t y A , a n d s i m i l a r l y f o r

    S B

    a n d B j .5 I n t h i s

    n e t w o r k , t h e r e a r e t w o t y p e s o f l o c a l p h o n e c a l l s A i S A A ~ a n d B i S B B ~, a s w e l l a s

    AS

    and B S can also be components of substitute phone calls A S C and BSC.

    The 1994 spectrum auction will allow for a large two-way paging network.

    5In this network, we may identify end-nodes, such as A and B , end-links, such as ASA and SsB~, the

    interface or gatew ay SAS~, and switches SA and SR.

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    676

    N. Economides / Int. J. Ind. Orga n. 14 1996) 673-6 99

    A B B2

    A

    S B

    Fig. 3. A sim ple local and lon g distance network.

    l ong d i s t ance phone ca l l

    AiSASBBj .

    W e can a l so i n t e rp r e t the ne two rk o f F ig . 3 a s

    a n a u to m a t i c te l le r m a c h i n e n e t w o r k A T M ) . T h e n a t r a n s a c ti o n s a y a w i t h d r a w a l )

    f r o m b a n k B j f r o m A T M A i is A f l A S B B . C o n n e c t i o n s A f l a A k a n d B j S s B ~ m a y b e

    f e a s i b l e b u t t h e r e i s n o d e m a n d f o r t h e m .

    W e h a v e p o i n t e d o u t e a r l i e r t h a t t h e c r u c i a l r e l a t i o n s h i p i n b o t h o n e - w a y a n d

    t w o - w a y n e t w o r k s i s t h e c o m p l e m e n t a r i t y b e t w e e n t h e p i e c e s o f t h e n e t w o r k . T h i s

    c r u c i a l e c o n o m i c r e l a t i o n s h i p i s a l s o o f t e n o b s e r v e d b e t w e e n d i f f e r e n t c l a s s e s o f

    g o o d s i n n o n - n e t w o r k in d u s tr ie s . I n f a c t, E c o n o m i d e s a n d W h i t e 1 9 9 4 ) p o i n t o u t

    t ha t a pa i r o f ve r t i c a l l y r e l a t ed i ndus t r i e s i s f o rma l ly equ iva l en t t o a one -way

    n e t w o r k . F i g . 4 c a n r e p r e s e n t tw o i n d u s tr i e s o f c o m p l e m e n t a r y g o o d s A a n d B ,

    w h e r e c o n s u m e r s d e m a n d c o m b i n a t i o n s A~Bj. Not i ce t ha t t h i s f o rmu la t i on i s

    f o r m a l l y id e n t i ca l t o o u r l o n g - d i s ta n c e n e t w o r k o f F i g . 3 i n th e A T M i n t er p r e ta -

    t ion .

    T h e d i s c u s s io n s o f a r w a s c a r r ie d u n d e r t h e a s s u m p t i o n o f

    c o mp a t ib i l i t y ,

    i .e . that

    v a r i o u s l i n k s a n d n o d e s o n t h e n e t w o r k a r e c o s t l e s s l y c o m b i n a b l e t o p r o d u c e

    d e m a n d e d g o o d s . W e h a v e p o i n t e d o u t t h at l in k s o n a n e t w o r k a r e p o t e n t ia l l y

    c o m p l e m e n t a r y , b u t i t i s c o m p a t i b i l i ty t h a t m a k e s c o m p l e m e n t a r i t y a c t u a l . S o m e

    n e t w o r k g o o d s a n d s o m e v e r t i c a l l y r e l a t e d g o o d s a r e i m m e d i a t e l y c o m b i n a b l e

    b e c a u s e o f th e i r i n h e re n t p r o p e r ti e s . H o w e v e r , f o r m a n y c o m p l e x p r o d u c t s , a c t u a l

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    N . E c o n o m i d e s / I nt . J . I n d. O r g a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9 677

    A 1 A 2 A m

    B 1 1 32 B n

    Fig. 4. A pair of vertically related markets.

    complementarity can be achieved only through the adherence to specific technical

    compatibility standards. Thus, many providers of network or vertically related

    goods have the option of making their products partially or fully incompatible with

    components produced by other firms. This can be done through the creation of

    proprietary designs or the outright exclusion or refusal to interconnect with some

    firms.

    Traditionally, networks were analyzed under the assumption that each network

    was owned by a single firm. Thus, economic research focused on the efficient use

    of the network structure as well as on the appropriate allocation of costs 6 In the

    70s, partly prompted by the antitrust suit against AT T, there was a considerable

    amount of research on economies of scope, i.e. on the efficiency gains from joint

    operation of complementary components of networks.7

    Once one of the most important networks (the AT T telecommunications

    network in the US) was broken to pieces, economic research focused in the 80s

    and 90s on issues of interconnection and compatibility. Similar research on issues

    of compatibility was prompted by the reduced role of IBM in the 80s and 90s in

    the setting of technical standards in computer hardware and software. Significant

    reductions in costs also contributed and will contribute to the transformation

    toward fragmented ownership in the telecommunications sector in both the United

    States and abroad. Costs of transmission have fallen dramatically with the

    introduction of fiberoptic lines. Switching costs have followed the fast cost

    See

    Sharkey (1995) for an excellent survey.

    7See Baumol et al. (1982).

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    N. Economides / Int. J. Ind. Organ. 14 1996) 673-699

    decreases of microchips and integrated circuits. These cost reductions have

    transformed the telecommunica tions industry from a natural monopo ly to an

    oligopoly• The same cost reductions have made many new services, such as

    interactive video and interactive games, feasible at low cost. Technological change

    now allows for joint trans mission of digital signals of various communica tions

    services. Thus, the monopoly of the last link closest to home is in the process of

    being eliminated,8 since both telephone lines and cable lines (and in some cases

    • 91

    PCS and terrestrial satellites) will provide similar services. '

    In a network where complementary as well as substitute links are owned by

    different firms, the questions of i nterconn ection, compatibili ty, interoperability,

    and coordination of quality of services become of paramou nt importance. We will

    examine these issues in detail in the next few sections. We first focus on a

    funda menta l property of networks, i.e. the fact that they exhibit network exter-

    nalities.

    3 N e t w o r k e x t e r n a li t ie s

    Networks exhibit positive consumption and production externalities. A positive

    consumption externality (or network externality) signifies the fact that the value of

    a unit of the good increases with the number of units sold. To economists, this fact

    seems quite cou nterintui tive, since they all know that, except for potatoes in Irish

    famines, market dema nd slopes downwards. Thus, the earlier statement, the value

    of a unit of a good increases with the numb er of units sold, should be interpreted

    as the value of a unit of the good increases with the expected numbe r of units to

    be sold. Thus, the dem and slopes downward but shifts upward with increases in

    the number of units expected to be sold.

    81t is already eliminated in some parts of the United Kingdom, where cable TV operators offer

    telephone service at significantly ower prices than British Telecom.

    9These significantchanges in costs and the convergenceof communications ervices open an number

    of policy questions on pricing, unbundling,deregulation, and possibly mandated segmentation n this

    sector. It is possible that ownership breakup of local and long distance lines is no longer necessary to

    improve competition. For example, European Unionpolicy mandates open competitionby 1998 in any

    part of the telecommunicationsnetwork, but does not advocate vertical fragmentationof the existing

    integrated national monopolies; see European Commission (1994). The reduction in costs and the

    elimination of natural monopoly in many services may make it possible for this policy to lead the

    industry to competition.

    ~°Another important network, the airline network, faces significantchange in Europe. Airlines have

    not benefited from significantcost reductions and technological change; the present reform is just the

    abolition by the European Union of the antiquated regime of national airline monopolies, and its

    replacement by a more competitive environment.

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    N. Economides / Int. J. Ind. Organ. 14 1996) 673-699

    679

    3.1. Sources o f network externalities

    The key reason for the appearance of network externalities is the complemen-

    tarity between the components of a network. Depending on the network, the

    externality may be direct or indirect. When customers are identified with

    components, the externality is direct. Consider for example a typical two-way

    network, such as the local telephone network of Fig. 2. In this n-component

    network, there are n n - 1) potential goods. An additional (n + l th) customer

    provides direct externalities to all other customers in the network by adding 2n

    potential new goods through the provision of a complementary link (say ES) to the

    existing links. 11

    In typical one-way networks, the externality is only indirect. When there are m

    varieties of component A and n varieties of component B as in Fig. 4 (and all

    A-type goods are compatible with all B-type), there are mn potential composite

    goods. An extra customer yields indirect externalities to other customers, by

    increasing the demand for components of types A and B and thereby (because of

    the presence of economies of scale) potentially increasing the number of varieties

    of each component that are available in the market.

    Financial exchange networks also exhibit indirect network externalities. There

    are two ways in which these externalities arise. First, externalities arise in the act

    of exchanging assets or goods. Second, externalities may arise in the array of

    vertically related services that compose a financial transaction. These include the

    services of a broker, of bringing the offer to the floor, matching the offer, etc. The

    second type of externalities are similar to other vertically related markets. The first

    way in which externalities arise in financial markets is more important.

    The act of exchanging goods or assets brings together a trader who is willing to

    sell with a trader who is willing to buy. The exchange brings together the two

    complementary goods, willingness to sell at price p (the off er ) and willingness

    to buy at price p (the counterof fer ) and creates a composite good, the exchange

    transaction. The two original goods were complementary and each had no value

    without the other one. Clearly, the availability of the counteroffer is critical for the

    exchange to occur. Put in terms commonly used in finance, minimal liquidity is

    necessary for the transaction to occur.

    Financial markets also exhibit positive size externalities in the sense that the

    increasing size (or thickness) of an exchange market increases the expected utility

    of all participants. Higher participation of traders on both sides of the market

    (drawn from the same distribution) decreases the variance of the expected market

    price and increases the expected utility of risk-averse traders. Ceteris paribus,

    ~ This property of two-way networks was pointed out in telecommunications networks by Rohlfs

    (1974) in a very early paper on network externalities. See also Oren and Smith (1981).

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    680 N. Economides / Int . J . Ind. Organ. 14 (1996) 673-699

    higher liquidity increases traders utility. Thus, financial exchange markets also

    exhibit network externalities.12 13

    3 .2 . T h e m a c r o a p p r o a c h

    There are two approaches and two strands of literature in the analysis of

    network externalities. The first approach assumes that network externalities exist,

    and attempts to model their consequences . I call this the mac ro approach.

    Conceptually this approach is easier, and it has produced strong results. It was the

    predominant approach during the 80s. The second approach attempts to find the

    root cause of the network externalities. I call this the mic ro approach. In

    industrial organization, it started with the analysis of mix-and-match models and

    has evolved to the analysis of various structures of vertically related markets. In

    finance, it started with the analysis of price dispersion models. The mic ro

    approach is harder, and in many ways more constrained, as it has to rely on the

    under lyin g microstrncture. However, the mic ro approach has a very significant

    benefit in defining the market structure. We discuss the mac ro approach first.

    3 . 2 .1 . P e r f e c t c o m p e t i t i o n

    As we have noted earlier, network externalities arise out of the complementarity

    of different network pieces. Thus, they arise naturally in both one- and two-way

    networks, as well as in vertically related markets. The value of good X increases as

    more of the com plem enta ry good Y is sold, and vice versa. Thus, more o f Y is sold

    as more X is sold. It follows that the value of X increases as more of it is sold.

    This positive feedback loop seems explosive, and indeed it would be, except for

    the inherent downward slope of the demand curve. To understand this better,

    consider a fulfilled expectations formulation of network externalities as in Katz

    and Shapiro (1985), Economides (1993b), Economides (1996a), and Economides

    and Himm elb erg (1995). Let the will ingnes s to pay for the nth uni t of the good

    ~2For a more detailed discussionof networks in finance see Economides (1993a). Economides and

    Schwartz (1995a) discuss how to set up electronic call markets that bunch transactions and execute

    them all at once. Call markets have inherentlyhigher liquiditybecause they take advantage of network

    externalities in exchange. Thus, transaction costs are lower in call markets. Economides (1994a) and

    Economides and Heisler (1994) discuss how to increase liquidity in cal l markets. The survey of

    institutional nvestorsreported by Economides and Schwartz (1995b) find that many raders who work

    in the present continuousmarket environmentwould be willing o wait a numberof hours for execution

    of their orders if they can save in transactioncosts, includingbid-ask spreads. Thus, the time is right for

    the establishmentof call markets in parallel operation with the continuousmarket.

    ~3The increase of utility in expectation due to market thickness was pointed out by Economides and

    Siow (1988), and earlier and in less formal terms by Garbade and Silber (1976a), Garbade and Silber

    (1976b), and Garbade and Silber (1979). The effects are similar to those of search models as in

    Diamond (1982) and Diamond (1984).

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    N . E c o n o m i d e s / In t. J . I n d . O r g a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9 681

    w h e n n e u n i ts a r e e x p e c t e d t o b e s o l d b e

    p n ; n e . 1 4

    T h i s i s a d e c r e a s i n g f u n c t i o n o f

    i ts f ir st a r g u m e n t b e c a u s e t h e d e m a n d s l o p e s d o w n w a r d , p n; n e) i n c r e a s e s i n n e ;

    t h i s c a p t u r e s t h e n e t w o r k e x t e r n a l i t i e s e f f e c t. A t a m a r k e t e q u i l i b r i u m o f t h e s i m p l e

    s i n g l e - p e r i o d w o r l d , e x p e c t a t i o n s a r e f u l f il l e d , n n e t h u s d e f i n i n g t h e f u l f i l l e d

    e x p e c ta t io n s d e m a n d

    p n, n).

    F i g . 5 s h o w s t h e c o n s t r u c t i o n o f a t y p i c a l f u l f il l e d

    e x p e c t a t i o n s d e m a n d . E a c h c u r v e D i, i = 1 . . . . 4 , s h o w s t h e w i l l i n g n e s s t o p a y f o r

    a v a r y i n g q u a n t i t y n , g i v e n a n e x p e c t a t i o n o f s a l e s n e = n i. A t n = n i , e x p e c t a t i o n s

    a r e f u l f i ll e d a n d t h e p o i n t b e l o n g s t o

    p n , n)

    a s

    p ni, ng).

    T h u s

    p n , n)

    i s c o n s t r u c t e d

    a s a c o l l e c t i o n o f p o i n t s

    p n i, n~).

    T o a v o i d e x p l o s i o n s a n d i n f i n it e s a l e s , i t i s r e a s o n a b l e t o i m p o s e l i m n _ ~

    p n ,

    n ) = 0 ; i t t h e n f o l l o w s t h a t

    p n , n)

    i s d e c r e a s i n g f o r l a r g e n . E c o n o m i d e s a n d

    H i m m e l b e r g 1 9 9 5 ) s h o w t ha t t h e f u lf i ll e d e x p e c t a t io n s d e m a n d i s i n c r e a s in g f o r

    s m a l l n i f e i t h e r o n e o f t h r e e c o n d i t i o n s h o l d : i ) the u t i l ity o f every consum er in a

    ne tw ork o f zero s ize i s zero , o r i i ) there are im med iate and large ex ternal bene fi ts

    to ne twork expans ion fo r ve ry sma l l ne tworks ,

    o r i i i )

    there is a s ignif icant density

    c,p

    D 1

    ~ /

    p n,n)

    f i

    n n 2 n 3 n 4 n °

    F i g . 5 . C o n s t r u c t i o n o f t h e f u l fi l l ed e x p e c t a t i o n s d e m a n d .

    n

    ] 4 In t h i s f o r m u l a t i o n n a n d n e a r e n o r m a l i z e d s o t h a t t h e y r e p r e s e n t m a r k e t s h a r e s r a t h e r t h a n

    a b s o l u t e q u a n t i t i e s .

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    682

    N . E c o n o m i d e s / I n t. J . I n d . O r g a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9

    o f h i g h -w i l l in g n e s s - to - p a y c o n s u m e r s w h o a r e j u s t i n d if fe r e n t o n j o i n i n g a n e t w o r k

    o f a p p r o x i m a t e l y z e r o s iz e . T h e f i r s t c o n d i t i o n i s s t r a i g h t f o r w a r d a n d a p p l i e s

    d i r e c t l y t o a l l t w o - w a y n e t w o r k s . T h e o t h e r t w o c o n d i t i o n s a r e a b i t m o r e s u b t l e ,

    b u t c o m m o n l y o b s e r v e d i n n e t w o r k s a n d v e r t i c a l l y r e l a t e d i n d u s t r i e s .

    W h e n t h e f u l fi l le d e x p e c t a t i o n s d e m a n d i n c r e a s e s f o r sm a l l n , w e s a y t h a t t h e

    n e t w o r k e x h i b i t s a p o s i t i v e c r i t i c a l m a s s u n d e r p e r f e c t c o m p e t i t io n . T h i s m e a n s

    t h at , i f w e i m a g i n e a c o n s t a n t m a r g i n a l c o s t c d e c r e a s i n g p a r a m e t r i c a l l y , t h e

    n e tw o r k w i l l s t a r t a t a p o s i t i v e a n d s i g n i f i c a n t s i z e n ° ( c o r r e s p o n d in g t o m a r g in a l

    c o s t c ° ) . F o r e a c h s m a l l e r m a r g in a l c o s t , c < c ° , t h e r e a r e t h r e e n e tw o r k s i z e s

    c o n s i s t e n t w i t h m a r g i n a l c o s t p r i c i n g : a z e r o s i z e n e t w o r k ; a n u n s t a b l e n e t w o r k

    s i z e a t t h e f ir s t i n t e r s e c t i o n o f t h e h o r i z o n t a l t h r o u g h c w i th p n , n ) ; a n d t h e P a r e to

    o p t i m a l s t a bl e n e t w o r k s i z e a t t h e l a r g e s t i n te r s e c t i o n o f t h e h o r i z o n t a l w i t h

    p n , n ) .

    T h e m u l t i p l i c i t y o f e q u i l ib r i a i s a d i r e c t r e s u l t o f th e c o o r d i n a t i o n p r o b l e m t h a t

    a r i s e s n a tu r a l l y i n t h e t y p i c a l n e tw o r k e x t e r n a l i t i e s m o d e l . I n s u c h a s e t t in g , i t i s

    n a tu r a l t o a s s u m e th a t t h e P a r e to o p t im a l n e tw o r k s i z e w i l l r e s u l t. 15

    I n t h e p r e s e n c e o f n e t w o r k e x t e r n a li t ie s , i t i s e v i d e n t t h a t p e r f e c t c o m p e t i t i o n i s

    i n e f fi c i en t : T h e m a r g i n a l s o c i a l b e n e f i t o f n e t w o r k e x p a n s i o n i s la r g e r th a n t h e

    b e n e f i t t h a t a c c r u e s t o a p a r t i c u l a r f i r m u n d e r p e r f e c t c o m p e t i t i o n . T h u s , p e r f e c t

    c o m p e t i t i o n w i l l p r o v i d e a s m a l l e r n e t w o r k t h a n i s s o c i a l l y o p t i m a l , a n d f o r s o m e

    r e l a t i v e l y h i g h m a r g i n a l c o s t s p e r f e c t c o m p e t i t i o n w i l l n o t p r o v i d e t h e g o o d w h i l e

    i t i s s o c i a l l y o p t im a l t o p r o v id e i t .

    O n e i n t e r e s t i n g q u e s t i o n t h a t r e m a i n s v i r t u a l l y u n a n s w e r e d i s h o w t o d e c e n t r a l -

    i z e t h e w e l f a r e m a x i m i z i n g s o l u t i o n i n t h e p r e s e n c e o f n e t w o r k e x t e rn a l it i es .

    C l e a r l y , t h e w e l f a r e m a x i m i z i n g s o l u t i o n c a n b e i m p l e m e n t e d t h r o u g h p e r f e c t

    p r i c e d i s c r i m i n a t i o n , b u t t y p i c a l l y s u c h d i s c r i m i n a t i o n i s u n f e a s i b le . I t r e m a i n s t o

    b e s e e n t o w h a t e x t e n t m e c h a n i s m s t h a t a ll o w f o r n o n - l i n e a r p r i c i n g a n d s e l f-

    s e l e c t i o n b y c o n s u m e r s w i l l c o m e c l o s e t o t h e f i r s t b e s t .

    3 . 2 . 2 . M o n o p o l y

    E c o n o m i d e s a n d H i m m e l b e r g ( 1 9 9 5 ) s h o w t h a t a m o n o p o l i s t w h o i s u n a b l e t o

    p r i c e - d i s c r i m i n a t e w i l l s u p p o r t a s m a l l e r n e t w o r k a n d c h a r g e h i g h e r p r i c e s t h a n

    p e r f e c t l y c o m p e t i t i v e f i r m s . T h i s i s d e s p i t e t h e f a c t t h a t t h e m o n o p o l i s t h a s

    i n f l u e n c e o v e r t h e e x p e c t a t i o n s o f th e c o n s u m e r s , a n d h e r e c o g n i z e s t h is i n f l u e n ce ,

    w h i l e n o p e r f e c t l y c o m p e t i t i v e f i rm h a s s u c h i n f lu e n c e . 16 I n f l u e n c e o v e r e x p e c t a -

    t i o n s d r i v e s t h e m o n o p o l i s t t o h i g h e r p r o d u c t i o n , b u t t h e m o n o p o l i s t s p r o f i t-

    m a x i m i z i n g t e n d e n c y t o w a r d s r e s t r i c t e d p r o d u c t i o n i s s t r o n g e r a n d l e a d s i t t o

    ~sIt is possible to have other shapes of the fulfilled expectations demand. In general p n , n ) is

    quasiconcave under weak conditions on the distribution of preferences and the network externality

    function. Then if none of the three causes mentioned above are not present the fulfilled expectations

    demand is downward sloping.

    ~rA monopolist unable to influence expectations will clearly produce less than a monopolist able to

    influence expectations.

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    N. Economides / Int. J. Ind. Organ. 14 1996) 673-699 683

    l o w e r p r o d u c t i o n l e v e l s t h a n p e r f e c t c o m p e t i t i o n . T h u s , c o n s u m e r s a n d t o t a l

    s u r p lu s w i l l b e l o w e r i n m o n o p o l y t h a n i n p e r f e c t c o m p e t i t i o n . T h e r e f o r e t h e

    e x i s t e n c e o f n e t w o r k e x t e r n a l i t i e s d o e s n o t r e v e r s e t h e s t a n d a r d w e l f a r e c o m -

    p a r i s o n b e t w e e n m o n o p o l y a n d c o m p e t i t i o n ; i t f o l l o w s t h a t

    the existence of

    network externalities cannot be claimed as a reason in favor of a monopoly

    market structure.

    3.2.3. Oligopoly and monopolistic competition under compatibility

    C o u r n o t o l i g o p o l i s t s p r o d u c i n g c o m p a t i b l e c o m p o n e n t s a l s o h a v e s o m e i n -

    f l uence ove r expec t a t i ons . A na tu r a l w ay t o mode l t he i n f luence o f o l i gopo l i s t s on

    ou tpu t expec t a t i ons i s t o a s sume tha t eve ry o l i gopo l i s t t ake s t he ou tpu t o f a l l

    o t h e r s a s g i v e n a n d s e t s t h e e x p e c t a t i o n o f c o n s u m e r s o f h i s o w n o u t p u t . I n t h i s

    s e tt in g , M c o m p a t i b l e C o u r n o t o l i g o p o li s ts s u p p o r t a n e t w o r k o f a si z e b e t w e e n

    m o n o p o l y ( M = 1 ) a n d p e r f e c t c o m p e t i t i o n ( M = 2 ) . T h e a n a l y s i s c an e a s i l y b e

    e x t e n d e d t o m o n o p o l i s t i c c o m p e t i t i o n a m o n g c o m p a t i b l e o l i g o p o l i s t s i f f i r m s f a c e

    d o w n w a r d - s l o p i n g a v e r a g e c o s t c u r v e s a s s h o w n i n F i g . 6 . F i r m s p r o d u c e o n t h e

    d o w n w a r d - s l o p i n g p a r t o f t h e f i r m - s c a l e d f u lf i ll e d e x p e c t a ti o n s d e m a n d . A t a

    s y m m e t r i c e q u i li b r iu m , f i rm j s o u t p u t i s d e t e r m i n e d a t t h e i n t e rs e c ti o n o f

    m a r g i n a l c o s t c a n d m a r g i n a l r e v e n u e MRj. Pr ice i s read o f f the fu l f i l l ed

    e x p e c t a t i o n s f i r m - s c a l e d i n v e r s e d e m a n d

    p Mq, Mq).

    A t a m o n o p o l i s t i c a l l y

    c o m p e t i t i v e e q u i l i b r i u m , t h e AC cu rve i s t angen t t o t he fu l f i l l ed expec t a t i ons

    demand a t q~ .

    M o n o p o l i s t i c C o m p e t i t i o n w i t h N e t w o r k

    E x t e rn a l it ie s a n d M C o m p a t ib l e G o o d s

    C 0 _ ~ _ - _ .

    . ; - A c

    J

    qO qj q

    Fig. 6. M onopolistic com petition with n etwo rk externalities and M com patible goods.

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    68 N. Economides / Int. J. Ind. Organ. 14 1996) 673-699

    3 2 4 O l igopo ly unde r incom pa t ib i l it y

    O n e o f t h e m o s t i n te r e s t in g i s s u e s in th e e c o n o m i c s o f n e t w o r k s i s t h e

    i n t e r a c t io n o f o l i g o p o l i s t s p r o d u c i n g i n c o m p a t i b l e g o o d s . A f u l l a n a l y s i s o f s u c h a

    m a r k e t , i n c o n j u n c t i o n w i t h t h e a n a l y s i s o f c o m p a t i b l e o l i g o p o l i s t s , w i ll a l l o w u s

    t o d e t e r m i n e t h e i n c e n t i v e s o f i n d i v i d u a l f i rm s t o c h o o s e t e c h n o l o g i e s t h a t a r e

    c o m p a t i b l e o r i n c o m p a t i b l e w i t h o t h e rs .

    G i v e n a n y s e t o f fi r m s S = { 1 . . . . . N } , w e c a n i d e n t i f y a s u b s e t o f S t h a t a d h e r e s

    t o t h e s a m e t e c h n i c a l s t a n d a r d a s a c o a l i ti o n . T h e n t h e p a r t i ti o n o f S i n t o s u b s e t s

    d e f in e s a c o a l i t i o n s t r u c tu r e C s = { C 1 . . . . C k } . C o m p a t i b i l i t y b y a l l f i rm s m e a n s

    th a t t h e r e i s a s i n g l e c o a l i t i o n t h a t i n c lu d e s a l l f i r m s . T o t a l i n c o m p a t ib i l i t y , w h e r e

    e v e r y f i r m a d h e r e s t o it s o w n u n i q u e s t a n d a rd , m e a n s t h a t k = N .

    A n u m b e r o f c r i te r i a c a n b e u s e d t o d e f in e t h e e q u i l i b r i u m c o a l i t i o n s t r u ct u r e . A

    p u r e l y n o n - c o o p e r a t i v e c o n c e p t w i t h o u t s i de p a y m e n t s r e q u i r e s t h a t, a f t e r a f i r m

    j o i n s a c o a l it i o n , i t is b e t te r o f f at th e r e s u l t i n g m a r k e t e q u i l i b ri u m , j u s t f r o m

    r e v e n u e s f r o m i ts o w n s a le s . ~7 A t a n o n - c o o p e r a t i v e e q u i l i b r i u m w i t h s i d e

    p a y m e n t s , f i rm s d i v i d e t h e p r o f it s o f a c o a l i ti o n a r b i t r a ri l y t o i n d u c e f i r m s t o j o i n a

    c o a l i t i o n . Y e t f i r m s d o n o t c o o p e r a t e i n o u t p u t d e c i s i o n s . K a t z a n d S h a p i r o ( 1 9 8 5 )

    s h o w t h a t th e l e v e l o f in d u s t r y o u t p u t i s g r e a t e r u n d e r c o m p a t i b i l i t y t h a n a t a n y

    e q u i l i b r i u m w i t h s o m e i n c o m p a t i b l e f i r m ( s ) . T h i s i s n o t s u f f i c i e n t t o c h a r a c t e r i z e

    t h e i n c e n t i v e s o f f i r m s t o o p t f o r c o m p a t i b i l i t y .

    I n t u i t i v e l y , a f i r m b e n e f i t s f r o m a m o v e t o c o m p a t i b i l i t y i f ( i ) t h e m a r g i n a l

    e x t e r n a l i t y i s s t r o n g ; ( i i ) it j o in s a l a r g e c o a l i t i o n ; a n d ( i i i) i t d o e s n o t t h e r e b y

    i n c r e a s e c o m p e t i t i o n t o a s i g n i f i c a n t d e g r e e b y i t s a c t i o n . O n t h e o t h e r h a n d , t h e

    c o a l i t i o n b en e f i ts f r o m a f i rm j o i n i n g i ts s t a n d a r d i f ( i) t h e m a r g i n a l e x t e r n a l i t y i s

    s t r o n g ; ( i i ) t h e f ir m th a t j o in s t h e c o a l i t i o n i s l a r g e ; ( i i i ) c o m p e t i t i o n d o e s n o t

    i n c r e a s e s i g n i f ic a n t l y a s a r e s u l t o f t h e f i r m j o i n i n g t h e c o a l i t io n . C l e a r l y , i n b o t h

    c a s e s , t h e s e c o n d a n d t h e t h i r d c r i t e r i a m a y c r e a t e i n c e n t i v e s t h a t a r e i n c o n f l i c t ;

    t h i s w i l l h e lp d e f in e t h e e q u i l i b r i u m c o a l i t i o n s t r u c tu r e . 18

    K a t z a n d S h a p i r o ( 1 9 8 5 ) s h o w t h a t i f t h e c o s t s o f a c h i e v i n g c o m p a t i b i l i t y a r e

    l o w e r f o r a ll f i rm s t h a n t h e i n c r e a s e i n p r of i ts b e c a u s e o f c o m p a t i b i l i t y , t h e n t h e

    i n d u s t r y m o v e t o w a r d c o m p a t i b i l i t y i s s o c i a l l y b e n e f i c i a l . H o w e v e r , i t m a y b e t r u e

    t h a t t h e ( f i x e d ) c o s t o f a c h i e v i n g c o m p a t i b i l i t y i s l a r g e r t h a n t h e i n c r e a s e i n p ro f i ts

    f o r s o m e f i r m s , w h i l e t h e s e c o s t s a r e l o w e r t h a n t h e i n c r e a s e i n t o t a l s u r p l u s f r o m

    c o m p a t i b i l i t y . T h e n p r o f i t m a x i m i z i n g f i r m s w i l l n o t a c h i e v e i n d u s t r y - w i d e

    c o m p a t i b i l i t y w h i l e t h i s r e g i m e i s s o c ia l l y o p t im a l . F u r t h e r, i f a c h a n g e l e a d s t o

    l e s s t h a n i n d u s t r y - w i d e c o m p a t i b i l i t y , t h e p r i v a t e i n c e n t i v e s t o s t a n d a r d i z e m a y b e

    e x c e s s i v e o r i n a d e q u a t e . T h i s i s b e c a u s e o f t h e o u t p u t c h a n g e s t h a t a c h a n g e o f

    r e g i m e h a s o n a l l f ir m s . S i m i l a r l y , t h e i n c e n t i v e o f a f i rm t o p r o d u c e a o n e - w a y

    a d a p t e r , t h a t a l l o w s i t t o a c h i e v e c o m p a t i b i l i t y w i t h o u t a f f e c t i n g t h e c o m p a t i b i l i t y

    ~TSee Econ om ides (1984 ), Yi a nd Shin (19 92a), and Yi and Shin (1992b ).

    ~8Economides and Flyer (199 5) ex amine the incentives for co alition formation around compatibility

    standards.

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    N . E c o n o m i d e s / I n t. J . I n d . O r g a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9 6 8 5

    o f o t h e r f i rm s , m a y b e d e f i ci e n t o r e x c e s s i v e b e c a u s e t h e f i rm i g n o r e s t h e c h a n g e i t

    c r e a t e s o n o t h e r f i r m s p r o f i t s a n d o n c o n s u m e r s s u r p l u s .

    3.2.5. Coordination to technical standards with asymmetric technologies

    S o f a r i t w a s a s s u m e d t h a t t h e c o s t o f s t a n d a rd i z a t io n w a s f ix e d a n d t h e s a m e f o r

    bo th f i rms . I f s t anda rd i za t i on cos t s a r e d i f f e r en t , f irms p l ay a s t anda rds coo rd ina -

    t i on gam e . A 2 × 2 ve r s i on o f t h i s gam e i s p r e sen t ed i n F ig . 7 . En t r ie s r ep r e sen t

    p ro f it s . I n th i s game , we w i l l a s sum e tha t f i rm i ha s h ighe r p ro f it s when i t s

    s t anda rd i ge t adop t ed , a > g , b < h . P ro f i ts , in c a se o f d i s ag reem en t , w i ll depen d

    o n t h e p a r t ic u l a rs o f th e i n d u s tr y . O n e s t a n d ar d a s s u m p t i o n t h a t c a p tu r e s m a n y

    indus t r i e s i s t ha t i n c a se o f d i s ag reemen t p ro f i t s w i l l be l ower t han t hose o f e i t he r

    s t an d a r d , e , c < g ;

    d, f e b > d . S i m i l a rl y S t a n d a r d 2 i s a n e q u i l i b r i u m i f g > c h > f .

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    686

    N. Economides / Int. J. Ind. Organ. 14 1996) 673-699

    e a c h t y p e o f g o o d h a s a n u m b e r o f b r a n d s a v a i l a b le , A i , i = 1 . . . . m , B j, j = 1 . . . .

    n , a s i n F i g . 4 . L e t c o n s u m e r s d e m a n d 1 : 1 c o m b i n a t i o n s AkBJ.W e c a l l e a c h o f t h e

    c o m p l e m e n t a r y g o o d s A i o r ~ components w h i l e t h e c o m b i n e d g o o d AiBj is

    c a l l e d a composite good o r system. P o te n t i a l l y a l l c o m b in a t i o n s A ~ Bj , i = 1 . . . . m ;

    j = 1 . . . . n , a r e p o ss i b l e. T h u s c o m p l e m e n t a r i t y e x i s t s i n p o t e n t ia l . C o m p l e m e n -

    t a r it y i s a c t u a l i z e d w h e n t h e c o m p o n e n t s A i a n d B j a re c o m b i n a b l e a n d f u n c t i o n

    t o g e t h e r w i t h o u t e x t r a c o s t , i . e . w h e n t h e c o m p o n e n t s a r e compatible. O f te n i t i s a n

    e x p l i c i t d e c i s i o n o f t h e p r o d u c e r s o f in d i v i d u a l c o m p o n e n t s t o m a k e t h e i r p r o d u c t s

    c o m p a t i b l e w i t h t h o s e o f o t h e r p r o d u c e r s . T h u s , c o m p a t i b i l i t y i s a strategic

    d e c i s i o n a n d s h o u l d b e a n a l y z e d a s s u c h .

    M o d e r n i n d u s t ri a l o r g a n i z a t i o n p r o v i d e s a r i c h c o l l e c t i o n o f e n v i r o n m e n t s f o r

    t h e a n a l y s i s o f s t r a te g i c d e c i s i o n s ; b e c a u s e o f s h o r t a g e o f t i m e a n d s p a c e , t h i s

    s u r v e y w i l l d i s c u s s t h e d e c i s i o n o n c o m p a t i b i l i t y o n l y i n f e w e n v i r o n m e n t s .

    3.3.1. Mix and match: compatibility vs. incompatibility

    T h e mix-and-match l i t e r a t u r e d o e s n o t a s s u m e a p r i o r i n e t w o r k e x t e r n a l i t i e s ;

    h o w e v e r , i t i s c l e a r th a t d e m a n d i n m i x - a n d - m a t c h m o d e l s exhibits n e t w o r k

    e x t e rn a l it i es . T h e m i x - a n d - m a t c h a p p r o a c h w a s o r i g i n a t e d b y M a t u t e s a n d

    R e g i b e a u 1 9 8 8 ) , a n d f o l l o w e d b y E c o n o m i d e s 1 9 8 8 ) , E c o n o m i d e s 1 9 8 9 ) ,

    E c o n o m i d e s 1 9 9 l a) , E c o n o m i d e s 1 9 9 l b ), E c o n o m i d e s 1 9 9 3 c ), E c o n o m i d e s a n d

    S a l o p 1 9 9 2 ) , E c o n o m i d e s a n d L e h r 1 9 9 5 ) , M a t u t e s a n d R e g i b e a u 1 9 8 9 ) ,

    M a t u t e s a n d R e g i b e a u 1 9 9 2 ) , a n d o t h e r s . T o fi x i d e as , c o n s i d e r t h e c a s e o f F i g . 4

    w i t h m = 2 , n = 2 , t e c h n o l o g i e s a r e k n o w n , c o o r d i n a t i o n i s c o s t l e s s , p r i c e

    d i s c r i m i n a t i o n i s n o t a l l o w e d , a n d t h e r e a r e n o c o s t a s y m m e t r i e s c r e a t e d b y a n y

    p a r t i c u l a r c o m p a t i b i l i t y s t a n d a r d . F i g . 8 s h o w s t h e c a s e o f c o m p a t i b i l i t y . T h e

    i n c e n t i v e f o r c o m p a t i b i l i t y o f a v e r ti c a l l y i n t e g r a te d f i rm p r o d u c i n g A 1 a n d B ~ )

    d e p e n d s o n t h e r e la t iv e s i z e s o f e a c h c o m b i n a t i o n o f c o m p l e m e n t a r y c o m p o n e n t s .

    R e c i p r o c a l c o m p a t i b i l i ty , i .e . s i m u l t a n e o u s c o m p a t i b i l i t y b e t w e e n A I a n d B 2 , a s

    w e l l a s b e t w e e n

    A 2

    a n d B ~ ) i n c r e a s e s d e m a n d b y a l l o w i n g f o r th e s a le o f A

    IB 2

    a n d

    A z B I )

    b u t a ls o in c r e a s e s c o m p e t i t i o n f o r th e i n d i v id u a l c o m p o n e n t s . T h e r e -

    A A 2

    B B 2

    Fig. 8. Mix and match compatibility.

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    687

    f o re , w h e n t h e h y b r i d d e m a n d i s l a rg e c o m p a r e d w i th t h e o w n - p r o d u c t d e m a n d

    ( i n c l u d i n g t h e c a s e w h e r e t h e t w o d e m a n d s a r e e q u a l a t e q u a l p r ic e s ) , a f ir m h a s a n

    i n c e n t i v e t o w a n t c o m p a t i b i l i t y .2° W h e n t h e d e m a n d f o r h y b r i d s i s s m a l l , a fi r m

    d o e s n o t w a n t c o m p a t i b i l i ty • T h u s , i t is p o s s i b l e , w i t h t w o v e r t i c a l l y i n t e g r a t e d

    f ir m s , t h a t o n e f i rm w a n t s c o m p a t i b i l i t y ( b e c a u s e i t h a s s m a l l o w n - p r o d u c t d e m a n d

    c o m p a r e d w i t h t he h y b r i d s d e m a n d ) w h i l e th e o t h e r o n e p r ef e rs i n c o m p a t i b i l i t y

    ( b e c a u s e i ts o w n - p r o d u c t d e m a n d is l ar g e c o m p a r e d w i t h th e h y b r i d s d e m a n d ) .

    T h u s , t h e r e c a n b e c o n f l ic t a c r o s s f ir m s i n t h e i r in c e n t i v e s f o r c o m p a t i b i l i t y , e v e n

    w h e n t h e te c h n o l o g y i s w e l l k n o w n . T h e p r e s u m p t i o n i s t h a t o p p o n e n t s w i l l n o t b e

    a b l e t o c o u n t e r a c t a n d c o r r e c t a l l i n c o m p a t i b i l i t i e s i n t r o d u c e d b y a n o p p o n e n t , a n d ,

    t h e r e fo r e , i n s i t u a t io n s o f c o n f l ic t w e e x p e c t t h a t i n c o m p a t i b i l i t y w i n s.

    T h e s e r e s u l t s h o l d b o t h f o r z e r o - o n e d e c i s i o n s ( i .e . c o m p a t i b i l i t y v s . i n c o m -

    p a t i b i l i t y ) a n d f o r d e c i s i o n s o f p a r t i a l ( o r v a r i a b l e ) in c o m p a t i b i l i t y . T h e i n t u i ti o n o f

    t h e p r o - c o m p a t i b i l i t y r e s u l t fo r t h e z e r o - o n e d e c i s i o n i n th e e q u a l h y b r i d - a n d

    o w n - d e m a n d i s s i m p l e . S t a r ti n g f ro m t h e s a m e l e v e l o f p r i c e s a n d d e m a n d i n b o t h

    t h e c o m p a t i b i l i t y a n d i n c o m p a t i b i l i t y r e g i m e s , c o n s i d e r a p r i c e i n c r e a s e i n o n e

    c o m p o n e n t t h a t p r o d u c e s t h e s a m e d e c r e a s e i n d e m a n d i n b o t h r e g i m e s . U n d e r

    i n c o m p a t i b i l i t y , th e l o s s o f p r o f it s i s h i g h e r s i n c e

    systems

    s a l e s a r e l o s t r a t h e r t h a n

    s a l e s o f

    one component.

    T h e r e f o r e , p r o f i t s a r e m o r e r e s p o n s i v e t o p r i c e u n d e r

    i n c o m p a t i b i l i t y ; i t f o l l o w s t h a t t h e r e s i d u a l d e m a n d f a c i n g f i rm s i s m o r e e l a s t i c

    u n d e r i n c o m p a t i b i l i t y , a n d t h e r e f o r e f i rm s w i l l c h o o s e l o w e r p r i c e s in t h a t

    r e g i m e . 2 T h i s i s re m i n i s c e n t o f C o u r n o t s ( 1 8 3 8 ) c e l e b r a t e d r e s u l t ( s e e C o u r n o t ,

    1 9 2 7 ) t h a t a v e r t i c a l l y i n t e g r a t e d m o n o p o l i s t f a c e s a m o r e e l a s t i c d e m a n d a n d w i l l

    c h o o s e a l o w e r p r i c e t h a n t h e s u m o f t he p r i c e s o f tw o v e r t i c a l l y d i s i n t e g r a t e d

    m o n o p o h s t s .

    S o f a r w e h a v e a s s u m e d t h a t c o m p a t i b i l i t y i s r e c i p r o c a l - i .e . t h a t t h e s a m e

    a d a p t e r i s re q u i r e d t o m a k e b o t h A ~B2 a n d

    A2B ~

    f u n c t i o n a l. I f c o m p a t i b i l i t y i s n o t

    r e c i p r o c a l ( i .e . i f d i f f e r e n t a d a p t e r s a r e r e q u i r e d f o r A ~B2 a n d A 2 B1 ) t h e i n c e n t i v e

    o f fi r m s to a c h i e v e c o m p a t i b i l i t y d e p e n d s o n t h e c r o s s s u b s t i t u t i o n b e t w e e n

    o w n - p r o d u c t s a n d h y b r id s . R o u g h l y , i f t h e s u b s t it u t ab i l it y a m o n g A - t y p e c o m -

    p o n e n t s i s e q u a l t o th e s u b s t i t u t a b i l i ty a m o n g B - t y p e c o m p o n e n t s , t h e e a r l ie r

    r e s u l t s o f t h e r e c i p r o c a l s e t u p s t il l h o l d .23 N e v e r t h e l e s s , i f t h e d e g r e e o f s u b -

    s t i t u ta b i l i t y a m o n g t h e A s i s d i f f e r e n t t h a n a m o n g t h e B s , o n e f i rm m a y c r e a t e a n

    2C~Matutes and Regibeau (1988) and Econom ides (1989) find that co mpatibility is always the firms

    choice becau se the y assume a locational setting w ith uniform distribution of consum ers in space that

    results in equ al ow n-product and hybrid dem ands at equal prices. The exp osition here follows the m ore

    general framework of Economides (1988) and Economides (1991a).

    Z These results also hold w hen f irm s can price discriminate between bu yers who buy the pure

    combination

    A~B

    and buyers w ho buy only one com ponent from firm i . Th us, f irms practice mixed

    bundling. See Matutes and Regibeau (1992) and Economides (1993c).

    22 See Eco nomides (1988) for a d iscussion of C ournot s result, and Econo mides and Salop (1992) for

    an extension of the result to (parallel) vertical integration among tw o pairs of vertically related firms.

    23Economides (1991a, p. 52).

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    a d v a n t a g e f o r i ts e l f b y i n t r o d u c i n g s o m e i n c o m p a t i b i li t ie s . H o w e v e r , i t is n e v e r to

    t h e a d v a n t a g e o f bo th ve r t i c a l l y i n t eg ra t ed f i rms t o c r ea t e i ncompa t ib i l i t i e s .

    T h e i s su e o f c o m p a t i b i li t y a n d c o o r d i n a t io n i s m u c h m o r e c o m p l i c a t e d i f t h e re

    a r e m o r e t h a n t w o f i r m s . A n u m b e r o f c o a l i t i o n s c a n e a c h b e f o r m e d a r o u n d a

    spec i f i c t e chn i ca l s t anda rd , and s t anda rds m ay a l l ow fo r pa r t i a l com pa t ib i l i t y , o r

    m a y b e m u t u a l l y i n c o m p a t i b l e . N o t e n o u g h r e s e a r c h h a s b e e n d o n e o n t h i s i s s u e .

    Resea rch i n t h i s a r ea i s made pa r t i cu l a r l y d i f f i cu l t by t he l a ck o f e s t ab l i shed

    m o d e l s o f c o a l i ti o n f o r m a t i o n i n n o n - c o o p e r a t i v e s e tt in g s . T h e a n a l y s i s b a s e d o n

    c o a l it i o n st ru c t u re s is m o r e c o m p l i c a t e d in t h e m i c r o a p p r o a c h b e c a u s e o f t h e

    spec i f i c s o f t he owne r sh ip s t ruc tu r e .

    The s tud i e s we r e f e r r ed t o t h i s f a r t ake t he owne r sh ip s t ruc tu r e a s g iven ( i . e . a s

    pa ra l l e l ve r t i c a l i n t eg ra t i on ) , and p roceed t o d i s cus s t he cho i ce o f t he deg ree o f

    compa t ib i l i t y . I n many ca se s , ve r t i c a l i n t eg ra t i on i s a dec i s ion t ha t i s more f l ex ib l e

    ( and l e s s i r r eve r s ib l e ) t han a dec i s ion on compa t ib i l i t y . Thus , i t makes s ense t o

    t h i n k o f a g a m e s t r u c t u r e w h e r e t h e c h o i c e o f t e c h n o l o g y ( w h i c h i m p l i e s t h e

    d e g r e e o f c o m p a t i b i l i t y ) p r e c e d e s t he cho i ce o f t he deg ree o f ve r t i c a l i n t eg ra t i on .

    E c o n o m i d e s ( 1 9 9 6 b ) a n a l y z e s th e c h o i c e o f a s s e t o w n e r s h i p a s a c o n s e q u e n c e o f

    t h e c h o i c e o f t e c h n o l o g y ( a n d o f t h e i m p l i e d d e g r e e o f c o m p a t i b i l i t y ) . I t p o s i t s a

    th r ee - s t age game o f compa t ib i l i t y cho i ce i n t he f i r s t s t age , ve r t i c a l i n t eg ra t i on i n

    the s econd s t age , and p r i ce cho i ce i n t he t h i rd s t age . I ncen t ive s fo r ve r t i c a l

    m e r g e r s i n i n d u st r ie s w i t h v a r y i n g d e g r e e s o f c o m p a t i b i l i t y a re c o m p a r e d . I n

    ana lyz ing t he s t age o f compa t ib i l i t y cho i ce , t he i n f l uence o f t he an t i c ipa t i on o f

    dec i s ions on (ve r t i c a l) i ndus t ry s t ruc tu r e on com pa t ib i l i t y dec i s ions i s eva lua t ed .

    (Fig. 9.)

    3 3 2 C h a n g e s i n t h e n u m b e r o f v a r ie t ie s a s a r e s u l t o f c o m p a t i b i li t y d e c i s i o n s

    E c o n o m i d e s ( 1 9 9 1 b ) c o n s i d e r s t h e i n t e r p l a y o f c o m p a t i b i l i t y a n d t h e n u m b e r o f

    v a r ie t ie s o f c o m p l e m e n t a r y g o o d s . T h e r e a r e t w o t y p e s o f g o o d s , A a n d B ,

    c o n s u m e d i n 1 :1 r a ti o . T h e r e a r e t w o b r a n d s o f g o o d A , A ~ a n d A 2, e a c h p r o d u c e d

    b y a n i n d e p e n d e n t f i r m . T h e n u m b e r o f B - t y p e b r a n d s , e a c h a l s o p r o d u c e d b y a n

    independen t f i rm , i s de t e rmined by a f r ee - en t ry cond i t i on , so t ha t i ndus t ry B i s i n

    m o n o p o l i s t i c c o m p e t i ti o n . I n a r e g i m e o f c o m p a t i b i li t y , e a c h B - t y p e c o m p o n e n t i s

    i m m e d i a t e l y c o m p a t i b l e w i t h e i t h e r A 1 o r A z . I n a r e g i m e o f i n c o m p a t i b i li t y , e a c h

    Stage Stage 2 Stage 3

    COMP TIBILITY

    OR

    INCOMP TIBILITY

    VERTIC L

    INTEGR TION OR

    DISINEGR TION

    PRICE

    COMPETITION

    F i g 9 C o m p a t i b i l i ty d e c i s i o n s a r e l e s s f l e x ib l e t h a n v e r ti c a l in t e g r a t i o n d e c i s i o n s

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    ompatibi l i ty

    F i g 1 0 C o m p a t i b i l i t y

    b r a n d B i p r o d u c e s t w o v e r s i o n s o n e c o m p a t i b l e w i t h A 1 a n d o n e c o m p a t i b l e w i t h

    A 2 . Th e tw o ca se s a r e show n in F ig . 10 and F ig . 11.

    Un de r i ncom pa t ib i l i t y e ach B- ty pe f i rm incu r s h ighe r f i xed cos t s ; i t f o l l ows t ha t

    c e t e ri s p a r i b u s t h e n u m b e r o f B - t y p e b r a n d s w i l l b e s m a l l e r u n d e r i n c o m p a t i b i li t y .

    A n A - t y p e f i r m p r e f e r s i n c o m p a t i b i l i t y o r c o m p a t i b i l i t y a c c o r d i n g t o t h e e q u i l i b -

    r u m pro f i ts it r e a l i z e s in e ach r eg im e . Thes e p ro f i ts and t he dec i s ion on

    com pa t ib i l i t y depen ds on the spec i f i c s o f t he u t i li t y func t i on o f consu m er s and in

    p a r t i c u l a r o n t h e i m p a c t o f a n i n c r e a s e o f t h e n u m b e r o f v a r i e t i e s o n u t i l i t y . I f

    ncompa t i b i l i t y

    a ; a j ... a

    F i g 1 1 In co mp a t i b i l t y

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    69 N. Economides / Int. J. Ind. Organ. 14 1996) 673-699

    i ndus t ry dem and i s no t s ens i t i ve to i nc r ea se s i n the num be r o f va r i e t i e s o f

    compos i t e goods n ( and does no t i nc r ea se much a s n i nc r ea se s ) , t hen equ i l i b r i um

    pro f i t s o f an A- type f i rm dec r ea se i n t he number o f f i rms ; t he r e fo r e p ro f i t s o f an

    A - t y p e f i r m a r e h i g h e r a t t h e s m a l l e r n u m b e r o f f i r m s i m p l i e d b y i n c o m p a t i b i l i t y ,

    a n d a n A - t y p e f i r m p r e f e r s i n c o m p a t i b i l i t y . C o n v e r s e l y , w h e n c o n s u m e r s h a v e a

    s t r o n g p r e f e r e n c e f o r v a r i e t y a n d d e m a n d f o r c o m p o s i t e g o o d s i n c r e a s e s s i g -

    n i f i c an t l y i n n , equ i l i b r i um p ro f i t s o f an A- type f i rm inc r ea se i n t he number o f

    f i rms ; t he r e fo r e i t s p ro f i t s a r e h ighe r a t t he l a rge r number o f f i rms imp l i ed by

    compa t ib i l i t y , and an A- type f i rm p re f e r s compa t ib i l i t y .

    C h u r c h a n d G a n d a l ( 1 9 9 2 b ) , C h o u a n d S h y ( 1 9 9 0 a ) , C h o u a n d S h y ( 1 9 9 0 b ) , a n d

    C h o u a n d S h y ( 1 9 9 0 c ) a l so e x a m i n e t h e im p a c t o f t h e n u m b e r o f v a r ie t ie s o f

    c o m p l e m e n t a r y ( B - t y p e ) g o o d s o n t h e d e c i s io n s o f c o n s u m e r s t o b u y o n e o f t he

    A - t y p e g o o d s u n d e r c o n d i t i o n s o f i n c o m p a t i b i l i t y .

    3.3.3. Quality coordination in mix and match

    T h e f r a m e w o r k o f m i x a n d m a t c h m o d e l s a p p l i es t o b o th v a r i e t y an d q u a l i ty

    f ea tu r e s t ha t a r e combinab l e add i t i ve ly i n t he u t i l i t y f unc t i on . Tha t i s , i n t he

    s t a n d ar d m i x - a n d - m a t c h m o d e l , t he u t il it y a c c r u in g t o a c o n s u m e r f r o m c o m p o n e n t

    A i is a d d e d t o t h e u t i li ty f r o m c o m p o n e n t B j . H o w e v e r , i n s o m e n e t w o r k s ,

    • • 24

    i n c lu d i n g t e l e c o m m u m c a t l o n s , t h e u t il it y o f t h e c o m p o s i t e g o o d A iB j is n ot t h e

    sum o f t he r e spec t i ve qua l i t ie s . I n pa r t i cu l a r , t he qua l i t y o f vo i ce i n a l ong d i s t ance

    ca l l i s t he min imum o f t he qua l i t i e s o f t he componen t pa r t s o f t he ne twork , i . e . t he

    loca l and t he l ong d i s t ance t r ansmi s s ion . Thus , s i gn i f i c an t qua l i t y coo rd ina t i on

    p r o b l e m s a r i s e i n a n e t w o r k w i t h f r a g m e n t e d o w n e r s h i p • E c o n o m i d e s ( 1 9 9 4 b ) a n d

    E c o n o m i d e s a n d L e h r ( 1 9 9 5 ) e x a m i n e t h i s c o o r d i n a t i o n p r o b l e m .

    Le t A and B be componen t s t ha t a r e combinab l e i n a 1 :1 r a t i o . Suppose t ha t t he

    q u a l i ty l e v e l s o f th e c o m p o n e n t s a r e qa and qB , wh i l e t he qua l i t y l eve l o f t he

    c o m p o s i t e g o o d i s qa8 = m i n (q A , q B ) C o n s u m e r s h a v e v a r y i n g w i l l in g n e s s t o p a y

    f o r q u a l i t y i m p r o v e m e n t s a s i n G a b s z e w i c z a n d T h i s s e ( 1 9 7 9 ) a n d S h a k e d a n d

    Su t ton (198 2 ) , and f i rms p l ay a two- s t ag e gam e o f qua l i ty cho i ce i n the f i r st st age ,

    f o l l o w e d b y p r i c e c h o i c e i n t h e s e c o n d s t a g e . A s m e n t i o n e d e a r l i e r , C o u r n o t

    ( 1 9 2 7 ) h a s s h o w n t h a t a n i n te g r a t e d m o n o p o l i s t p r o d u c i n g b o t h A a n d B w i l l

    c h a r g e l e s s th a n t w o v e r t i c a ll y re l a t ed m o n o p o l i s t s , e a c h p r o d u c i n g o n e c o m p o n e n t

    o n l y . T h i s i s b e c a u s e o f t h e e l i m i n a t io n o f d o u b l e m a r g i n a l iz a t i o n b y t h e

    i n t e g r a t e d m o n o p o l i s t • E c o n o m i d e s ( 1 9 9 4 b ) a n d E c o n o m i d e s a n d L e h r ( 1 9 9 5 )

    s h o w t h a t a n i n t e g r a t e d m o n o p o l i s t a l s o p r o v i d e s a h i g h e r q u a l i t y t h a n t h e t w o

    i n d e p e n d e n t m o n o p o l i s t s . I n b i la t e ra l m o n o p o l y , m a r g i n a l i n c r e a s e s i n q u a l it y h a v e

    a b igge r impac t on p r i ce . Be ing ab l e t o s e l l t he s ame qua l i t y a t a h ighe r p r i c e t han

    u n d e r i n t e g r a t e d m o n o p o l y , t h e b i l a t e r a l m o n o p o l i s t s c h o o s e l o w e r q u a l i t y l e v e l s ,

    wh ich a r e l e ss cos tl y • De sp i t e t ha t, because o f doub l e ma rg ina l i z a t i on , p r i c e s a r e

    Z4See also E ncaoua et al. (1992) fo r a discussion of the coordination of the timing of d ifferent legs

    of airport transportation.

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    691

    h i g h e r t h a n i n i n te g r a t e d m o n o p o l y , a l o w e r p o r t i o n o f t h e m a r k e t i s s e rv e d , a n d

    f i r m s r e a l i z e l o w e r p r o f i t s 25 T h u s ,

    l a c k o f v e r t i c a l i n t e g r a t i o n l e a ds t o a r e d u c t i o n

    i n q u a l i t y .

    N o t e t h a t th i s is n o t b e c a u s e o f l a c k o f c o o r d i n a t i o n b e t w e e n t h e

    b i l at e r al m o n o p o l i s t s i n t h e c h o i c e o f q u a l i t y , s i n c e t h e y b o t h c h o o s e t h e s a m e

    q u a l i t y l e v e l 2 6

    I n t h is s e t ti ng , E c o n o m i d e s a n d L e h r ( 1 9 9 5 ) e x a m i n e v a r i o u s o w n e r s h i p

    s t r u c tu r e s w h e r e , f o r a t le a s t o n e o f th e t y p e s o f c o m p o n e n t s t h e r e i s m o r e t h a n o n e

    q u a l i t y l e v e l a v a i l a b l e . C l e a r l y , a s i t u a t i o n w h e r e a l l c o m p o n e n t s h a v e t h e s a m e

    q u a l i t y i s n o t v i a b l e , s i n c e c o m p e t i t i o n w o u l d t h e n d r i v e p r i c e s t o m a r g i n a l c o s t .

    F u r t h e r, f o r a h i g h q u a l i t y c o m p o s i t e g o o d t o b e a v a i la b l e , b o t h a n A - a n d a

    B - t y p e g o o d s m u s t b e o f h i g h q u a l i ty . T h e y f in d t h a t a t h i rd (a n d f o u r t h ) l o w

    q u a l it y g o o d s h a v e a h a rd t i m e s u r v i v in g i f t h e y a re p r o d u c e d b y i n d e p e n d e n t

    f i r m s . I n c o n t r a s t , i n p a r a l l e l v e r t i c a l i n t e g r a t i o n ( w i th f i r m i , i = 1 , 2 , p r o d u c in g A i

    a n d B i ) , f i rm s p r e f e r n o t t o i n t e r c o n n e c t - i .e . to p r o d u c e c o m p o n e n t s t h a t a r e

    i n c o m p a t i b l e w i t h t h o s e o f t h e o p p o n e n t .

    4 N e t w o r k e x t e r n a li t ie s a n d i n d u s t r y st r u c t u r e

    4 . 1. I n v i t a t i o n s t o e n t e r

    I n th e p r e s e n c e o f s t r o n g n e t w o r k e x t e r n a li t ie s , a m o n o p o l i s t e x c l u s i v e h o l d e r o f

    a t e c h n o l o g y m a y h a v e a n i n c e n t iv e t o i n v i t e c o m p e t i t o r s a n d e v e n s u b s i d i z e t h e m .

    T h e r e a l i z a t i o n o f n e t w o r k e x t e r n a li t ie s r e q u i r es h i g h o u t p u t . A m o n o p o l i s t m a y b e

    u n a b l e c r e d i b l y t o c o m m i t t o a h i g h o u t p u t a s l o n g a s h e i s o p e r a t i n g b y h i m s e l f .

    H o w e v e r , i f h e l i c e n s es t h e t e c h n o l o g y to a n u m b e r o f f i rm s a n d i n v i t e s t h e m t o

    e n t e r a n d c o m p e t e w i t h h i m , m a r k e t o u t p u t w i l l b e h i g h e r ; a n d s i n c e t h e l e v e l o f

    m a r k e t o u t p u t d e p e n d s m a i n l y u p o n o t h e r f ir m s , th e c o m m i t m e n t t o h i g h o u t p u t i s

    c r e d ib l e .

    T h e i n v i t a t i o n t o e n t e r a n d t h e c o n s e q u e n t i n c r e a s e i n m a r k e t o u t p u t h a s t w o

    e f f e c t s ; a c o m p e t i t i v e e f f e c t a n d a n e t w o r k e f f e c t . T h e c o m p e t i t i v e e f f e c t i s a n

    e x p e c t e d i n c r e a s e i n c o m p e t i t i o n b e c a u s e o f t h e i n c r e a s e o f t h e n u m b e r o f f ir m s .

    T h e n e t w o r k e f f e c t t e n d s t o i n c r e a s e t h e w i l l i n g n e s s t o p a y a n d t h e m a r k e t p r i c e

    b e c a u s e o f t h e h i g h e x p e c t e d s al es . E c o n o m i d e s ( 1 9 9 3 h ) a n d E c o n o m i d e s ( 1 9 9 6 a )

    s h o w t h a t, i f th e n e t w o r k e x t e r n a l i t y i s s t r o n g e n o u g h , t h e n e t w o r k e f f e c t is l a r g e r

    t h a n t h e c o m p e t i t i v e e f f e c t , a n d t h e r e f o r e a n i n n o v a t o r - m o n o p o l i s t i n v i t e s c o m -

    p e t i t o r s a n d e v e n s u b s i d i z e s t h e m o n t h e m a r g i n t o i n d u c e t h e m t o i n c r e a s e

    p r o d u c t i o n .

    25Consumers also receive lower surplus in com parison to vertically integrated monopoly.

    26The reliability of the network, measured by the percentage of tim e that the netw ork is in operation,

    or by the probab ility of a successful connection, is mea sured by the prod uct of the respective

    reliabilities of the com pone nts (anoth er non-lin ear function).

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    692

    N. Economides / Int. J. Ind. Organ . 14 1996) 673 -69 9

    . 6

    B C

    3

    Fig. 12. AB is a bottleneck facility.

    4 .2 . I n t e r c o n n e c t i o n o r f o r e c l o s u r e b y a l o c a l m o n o p o l i s t ?

    Many telecommunications, airline networks and railroad networks have the

    structure of Fig. 12. In a railroad network, there may be direct consumer demand

    for links

    A B , B C ,

    as well as

    A C .

    This figure can also represent a telephone

    network with demand for local telephone services

    A B )

    and for long distance

    services

    A B C ) ;

    in that case, there is no direct demand for

    B C ,

    but only the

    indirect demand arising from long distance calls

    A B C .

    In many cases, one firm has

    a monopoly of a link that is necessary for a number of services here A B ) , and this

    link is a natural monopoly. This bottleneck link is often called an essential facility.

    The monopolist can foreclose any finn by denying access to the bottleneck facility.

    What are his incentives do so?

    Economides and Woroch 1992) examine intermodal competition in the context

    of a simple network pictured in Fig. 13. S and R are local switches;

    A S

    and

    B R

    is

    local service in different cities);

    S R

    and

    S T R

    are alternative long distance services.

    The diagram is simplified by eliminating R without any essential loss. Suppose

    that an integrated firm offers end-to-end service

    A S B ) ,

    while a second firm offers

    N et wo rk in Ex t en s ive an d o l l ap sed F o rm

    SI IT

    B

    Fig. 13. Intermodal competition.

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    s e r v i c e o f p a r ti a l c o v e r a g e o n l y

    STB) .

    T h e y f i n d t h a t , a l t h o u g h t h e i n t e g r a t e d f i r m

    h a s t h e o p p o r t u n i t y t o f o r e c l o s e t h e o p p o n e n t , i t p r e f e r s n o t t o . I n fa c t , the

    i n t e g ra t e d f i r m i s b e t t e r o f f b y i m p l e m e n t i n g a v e r t ic a l p r i c e s q u e e z e o n t h e

    opponen t , a n d c h a r g i n g a s i g n i f i c a n t l y h i g h e r p r i c e t o t h e o p p o n e n t f o r t h e u s e o f

    t h e m o n o p o l i z e d li n k t h a n i t c h a r g e s i ts e lf .27 T h u s , f o r e c lo s u r e , a l t h o u g h f e a s ib l e ,

    i s n o t o p t i m a l f o r t h e i n t e g r a t e d f i r m 2 8

    E c o n o m i d e s a n d W o r o c h ( 1 9 9 2 ) a l s o f i n d t h a t v e r t i c a l d i s i n t e g r a t i o n i s n o t

    d e s i r a b l e f o r t h e f i r m t h a t o f f e r s e n d - t o - e n d s e r v ic e . O n c e d i s i n te g r a t e d , i ts

    c o n s t i t u e n t p a r t s r e a l i z e l o w e r t o t a l p r o fi t s. T h i s i s b e c a u s e , b e s i d e s a p p r o p r i a t i n g

    m o n o p o l y r e n t s f o r i t s A S m o n o p o l y , t h e i n t e g r a t e d f i r m A S B ) w a s c r e a t i n g a

    s i g n i f i c a n t r e s t r ic t i o n o f c o m p e t i t i o n i n S B - S T B m a r k e t b y i t s d e f a c t o p r i c e

    d i s c r i m i n a t i n g s t r a te g y . A f t e r d is i n t e g r a ti o n , t h e S B - S T B m a r k e t b e c o m e s m u c h

    m o r e c o m p e t i t i v e , e v e n i f

    A S

    p r i c e d i s c r i m i n a t e s b e t w e e n

    S B

    a n d

    STB.

    T h u s , e v e n

    i f n e t w o r k A S B w e r e t o r e c e i v e t he f u ll r e n t ea r n e d b y t h e n e w o w n e r o f SB , its

    a f t e r - d iv e s t i t u r e p r o f it s w o u l d b e l o w e r t h a n b e f o r e d i v e s t it u r e 29

    E v e n i n s i m p l e n e t w o r k s , t h e r e m a y b e r e l a t i o n s a m o n g f i r m s t h a t a r e n e i t h e r

    p u r e l y v e r t i c a l n o r p u r e l y h o r i z o n t a l . T h u s , t h e c o n v e n t i o n a l w i s d o m a b o u t v e r t i c a l

    a n d h o r i z o n t a l i n t e g r a t i o n f a i l s . E c o n o m i d e s a n d S a l o p ( 1 9 9 2 ) d i s c u s s p r i c i n g i n

    v a r i o u s o w n e r s h i p s t r u c t u re s i n th e m o d e l o f F ig . 8 . T h e y c a l l t h e o w n e r s h i p

    s t r u c tu r e o f t h is f i gu r e , w h e r e e a c h f i rm p r o d u c e s a c o m p o n e n t o f e a c h t y p e ,

    para l l e l v e r t i ca l i n t egra t i on . T h e y a l s o c o n s i d e r t h e i n d e p e n d e n t o w n e r s h i p

    s t r u ct u r e , w h e r e e a c h o f t h e f o u r c o m p o n e n t s i s o w n e d b y a d i ff e r e n t f ir m . I n b o t h

    o f t h e s e s t r u c t u r e s, n o f i r m i s p u r e l y v e r t i c a l l y o r p u r e l y h o r i z o n t a l l y r e l a t e d t o

    a n o t h e r f ir m . T h u s , s t a r ti n g f r o m i n d e p e n d e n t o w n e r s h i p , o r s t a r ti n g f r o m p a r a l le l

    v e r t i c a l i n t e g r a t i o n , a m e r g e r t o

    j o i n t o w n e r s h i p ,

    w h e r e a l l c o m p o n e n t s a r e

    p r o d u c e d b y t h e s a m e f i rm , c a n e i t h e r i n c re a s e o r d e c r e a s e p r i c e s. T h u s , s i m p l e

    p r e s c r i p t i o n s a g a i n s t m e r g e r s m a y e a s i l y f a i l .

    I n th e m o d e l o f F ig . 1 3, E c o n o m i d e s a n d W o r o c h ( 1 9 9 2 ) c o n s i d e r t he c a s e

    w h e r e l i n k S T i s o w n e d b y a f i r m t h a t o w n s a v e r t i c a l l y r e l a t e d l i n k ( e i t h e r A S o r

    B T ) , o r is o w n e d b y a n i n d e p e n d e n t f i rm . C l e a r l y , t h e s t ra t e g i c s t r u c tu r e o f t h e

    g a m e r e m a i n s u n a f f e c t e d w h e n l i n k S T c h a n g e s h a n d s b e t w e e n t w o f i r m s t h a t a l s o

    o wn a l i n k t h a t i s v e r t i c a l l y r e l a t e d t o ST. T h e r e f o r e , i f S T has a f ixed cos t , i t i s a

    l i a b i l i t y t o s u c h a f i r m ; e a c h f i r m w o u l d l i k e t h e o p p o n e n t t o o w n i t . H o w e v e r , i f

    t h e l i n k i s o w n e d b y a th i r d p a r ty , i t i s h a s a p o s i t i v e v a lu e b e c a u s e o f i t s

    m o n o p o l y p o s i t i o n i n th e c h a i n . T h u s , e a c h o r i g i n a l o w n e r h a s a n i n c e n t i v e t o s el l

    S T

    t o a th i r d p a r t y . T h e d i r e c t i m p l i c a t i o n i s t h a t t h e v a l u e o f l in k s d e p e n d s o n

    7This

    result is dependent on the linear structure of the de mand system, and may not hold for any

    demand structure.

    28Church and Gand al (1992a) find that sometim es firms prefer foreclosure, but their m odel doe s not

    allow for a vertical price squeeze.

    9This

    result is in contrast to Bonanno and Vickers (1988) because of the absence of two-part

    contracts in Econom ides and W oroch (1992).

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    694

    N. Economides / Int . J . Ind. Organ. 14 1996 ) 67 3- 69 9

    w h a t o t h e r l i n k s a fi r m o w n s . T h u s , g e n e r a l p r e s c r i p t i o n s o n t h e d e s i r a b i l i t y o f

    u n b u n d l i n g o f o w n e r s h i p a r e s u s p e c t .

    O f t e n p a r t s o f t h e n e t w o r k a r e r e g u l a t e d , w h i l e o t h e r p a r t s a r e n o t. T h i s i s t h e

    t y p i c a l a r r a n g e m e n t i n te l e p h o n y i n t h e U S , w h e r e o n l y l o c a l t e le p h o n e c o m p a n i e s

    a r e t i g h t ly r e g u l a t e d , s i n c e t h e i r m a r k e t i s tr a d i t i o n a l l y c o n s i d e r e d a n a t u r a l

    m o n o p o l y . 3° B a u m o l a n d S i d a k 1 9 9 4 a ) a n d B a u m o l a n d S i d a k 1 9 9 4 b ) p ro p o s e

    t h a t, t o a t t ra c t e f f ic i e n t e n t r a n t s i n t h e l o n g d i s t a n c e m a r k e t a n d t o d i s c o u r a g e

    i n e f f ic i e n t e n t r a n ts , a l o c a l t e l e p h o n e c o m p a n y s h o u l d c h a r g e t h e m a n

    i n t e r c o n n e c -

    t io n o r a c c e s s ) f e e e q u a l t o t h e m a r g i n a l c o s t o f p r o v i s i o n o f s e r v i c e p l u s a n y

    o p p o r t u n i t y c o s t t h a t t h e l o c a l t e l e p h o n e c o m p a n y i n c u r s . 3 ~ T h i s i s c o r r e c t u n d e r a

    s e t o f s tr i ct a s s u m p t i o n s : f ir s t t h a t t h e e n d - t o - e n d g o o d i s s o l d o r i g i n a l l y a t t h e

    c o m p e t i t iv e p r ic e ; s e c o n d t h a t t h e e n tr a n t p r o d u c e s t h e s a m e c o m p l e m e n t a r y g o o d

    l o n g d i s t a n c e s e r v i c e) a s t h e i n c u m b e n t ; 32 t h ir d , t h a t t h e r e a r e n o e c o n o m i e s o f

    s c a le in e i th e r o n e o f t h e c o m p l e m e n t s . E c o n o m i d e s a n d W h i t e 1 9 9 5 ) a n d

    E c o n o m i d e s a n d W h i t e 1 9 9 6 ) d i s c u s s h o w t h e r e l a x a t io n o f t h e se a s s u m p t i o n s

    l e a d s to d i f fe r e n t in t e r c o n n e c t i o n c h a r g e s . F o r e x a m p l e , i f c o m p e t i t i o n b e t w e e n a n

    e n t ra n t a n d t h e in c u m b e n t r e d u c e s t h e m a r k e t p o w e r o f th e i n c u m b e n t , e n t r y m a y

    i n c r e a s e s o c i a l w e l f a r e e v e n w h e n t h e e n t r a n t p r o d u c e s a t h i g h e r c o s t t h a n t h e

    i n c u m b e n t .

    5 Sequent ia l gam es

    I n n e t w o r k m a r k e t s , a n d m o r e g e n e r a l l y i n m a r k e t s w i t h n e t w o r k e x t e r n a l i ti e s ,

    w h e n f i r m s a n d c o n s u m e r s i n t e r a c t i n m o r e t h a n p e r i o d ,

    h i s t o r y m a t t e r s .

    B o t h

    c o n s u m e r s a n d f i rm s m a k e p r o d u c t i o n a n d c o n s u m p t i o n d e c i s i o n s b a s e d o n s iz e s

    o f in s t a l l e d b a s e a n d o n e x p e c t a t i o n s o f it s i n c r e a s e s o v e r ti m e . T h e s a m e

    u n d e r l y i n g t e c h n o l o g y a n d c o n s u m e r s p r e f e r e n c e s a n d d i s t r ib u t i o n c a n l e a d t o

    d i f f e r e n t i n d u s t r i a l s t r u c t u r e s d e p e n d i n g o n t h e w a y t h i n g s s t a r t . T h u s , s t r a t e g i c

    a d v a n t a g e s , s u c h a s f ir s t m o v e r a d v a n t a g e s , c a n h a v e l o n g r u n e f f ec t s .33

    N e t w o r k e x t e r n a l i t ie s a n d h i s t o r i c a l e v e n t s a r e p a r t i c u l a r l y im p o r t a n t i n t h e

    s p e e d o f a d o p t i o n o f a n i n n o v a t i o n t h a t c r e a t e s s e r v i c e s o n a n e t w o r k . C a b r a l

    1 9 9 0 ) d i s c u s s e s t h e a d o p t i o n o f i n n o v a t i o n s u n d e r p e r f e c t c o m p e t i t i o n in t h e

    p r e s e n c e o f n e t w o r k e x t e r n a l i ti e s . H i s m a i n c o n c l u s i o n i s th a t, w h e n n e t w o r k

    e x t e r n a l i t ie s a re s t r o n g , th e e q u i l i b r i u m a d o p t i o n p a t h m a y b e d i s c o n t i n u o u s . T h i s

    3°This is chan ging for s om e customers through the existence of co mpetitive access providers, who

    directly c om pete w ith the local telephone com pan y for large customers, and the potential for

    comp etition by ca ble comp anies.

    3~ Kahn and Taylor 1994) h ave very similar views.

    32Armstrong and D oyle 1994) relax this assumption.

    33 See Arthur 1988), Arthur 1989), Da vid 1985). David argues that the QW ERT Y keyboard was

    adopted mainly because i t appeared f irst wh ile the DVO RAK keyboard was superior . This is disputed

    by Liebowitz and Margolis 1990).

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    23/27

    N . Eco n o mid es / I n t . J . I n d . Org a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9 695

    i s a n o t h e r w a y o f s a y i n g th a t t h e r e a r e t w o n e t w o r k s i z e s s u p p o r t e d a s e q u i l i b r i a a t

    t h e s a m e t i m e i n s ta n t . T h i s m a y o c c u r a t t h e s t a r t o f t h e n e t w o r k , a n d t h e n i t i s

    c a l l e d p o s i t iv e c r it ic a l m a s s b y E c o n o m i d e s a n d H i m m e l b e r g ( 1 9 9 5 ). I t m a y a l s o

    o c c u r a t o t h e r p o i n t s i n t h e n e t w o r k e v o l u t i o n . I n p r a c ti c e , d i s c o n t i n u i t ie s i n th e

    s i z e o f t h e n e t w o r k o v e r t i m e d o n o t o c c u r s i n c e t h a t w o u l d i m p l y a n i n f in i te s i z e

    o f s a le s a t s o m e p o i n ts i n t im e . C o n t i n u i ty a n d s m o o t h n e s s o f th e n e t w o r k p a t h i s

    r e s t o r e d i f i n s t a n t a n e o u s m a r g i n a l p r o d u c t i o n c o s t s ar e i n c r e a s i n g . U n d e r t h i s

    a s s u m p t i o n , E c o n o m i d e s a n d H i m m e l b e r g ( 1 9 9 5 ) f in d th a t t h e a d o p t i o n p a th i s

    m u c h s t e e p e r i n th e p r e s e n c e o f e x t e r n a li t ie s . F u r t h e r , d r i v e n b y t h e e x t e r n a l i ty , i n

    e a r l y s t a g e s t h e n e t w o r k c a n e x p a n d s o q u i c k l y a s t o e x h i b i t i n c r e a s i n g r e ta i l

    p r i c e s e v e n w h e n m a r g i n a l c o s t s a re f a ll i n g o v e r t im e . T h e i r a n a l y s i s is a p p l i e d t o

    t h e f a x m a r k e t i n t h e U S a n d J a p a n .

    T h e a n a l y s i s i s m o r e c o m p l e x w h e n w e d e p a r t f r o m th e a s s u m p t i o n o f p e r f e c t

    c o m p e t i t i o n . A c c o r d i n g l y , t h i s a n a l y s is t e n d s t o b e i n t h e f o r m o f s i m p l e t w o -

    p e r i o d m o d e l s . W e a n a l y z e i t w i t h r e f e r e n c e t o t h e s ta n d a r d s i m u l t a n e o u s c h o i c e

    c o o r d i n a t i o n g a m e o f S e c t i o n 3 . 2 .5 , w h e r e w e n o w i n t e r p re t t h e f ir s t s t r a t e g y a s

    s t i c k i n g t o t h e o l d t e c h n o l o g y , a n d t h e s e c o n d a s t h e a d o p t i o n o f a n e w o n e ( F i g .

    1 4 ). N e t w o r k e x t e r n a l i ti e s f o r b o t h t e c h n o l o g i e s m e a n t h a t a > c , e ; b > d , f ;

    g > c , e ; h > d , f . I f b o t h f i r m s a r e w o r s e o f f w h e n t h e y a r e n o t c o o r d i n a t e d , b o t h

    t h e ' n e w t e c h n o l o g y ' ( i. e. (N , N ) ) a n d t h e ' o l d t e c h n o l o g y ' ( i. e. ( O , O ) ) w i l l a ri s e

    a s e q u i l ib r i a . C l e a r l y , o n e o f t h e e q u i l i b r i a c a n b e i n e f f ic i e n t . I f t h e ( O , O )

    e q u i l i b r i u m i s i n e f f i c ie n t a n d i s a d o p t e d , F a r r e l l a n d S a l o n e r ( 1 9 8 5 ) c a l l th e

    s i t u a t i o n excess in er t i a 34 S i m i l a r l y , i f t h e ( N , N ) e q u i l i b r i u m i s i n e f f i c i e n t a n d i t is

    a d o p t e d , t h e s i tu a t i o n i s c a l l e d e x c e s s m o m e n t u m

    F a r re l l a n d S a l o n e r ( 1 9 8 5 ) d i s c u s s a t w o - p e r i o d m o d e l w h e r e c o n s u m e r s h a v e

    v a r y i n g w i l li n g n e s s t o p a y f o r t h e c h a n g e o f t h e t e c h n o l o g y , m e a s u r e d b y 0 . U s e r s

    c a n s w i t c h i n P e r i o d 1 o r 2 , a n d s w i t c h i n g i s i r r e v e r s i b l e . U s e r s f a l l i n f o u r

    c a t e g o r i e s a c c o r d i n g t o t h e s t r a t e g y th e y p i c k : ( i ) t h e y n e v e r s w i t c h , w h a t e v e r t h e

    b e h a v i o r o f o t h e r s i n t h e f i rs t p e r i o d ; ( i i) t h e y s w i t c h i n P e r i o d 2 i f o t h e r u s e r s

    P laye r 2

    N ew Techno logy O ld Techno logy

    N . . . O

    P layer 1

    N ew Technology,,N,, l a, b) c, d)

    O l d T e c h n o l o g y e , f ) g , h )

    O

    Fig. 14.

    34See Katz and Shap i ro 1992) fo r a d i f fe ren t v iew argu ing fo r excess mom entum which they ca l l

    in su f f ic ien t f r ic t io n ) .

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    696

    N. Economides / Int. J. Ind. Organ. 14 1996) 673-699

    h a v e s w i t c h e d i n P e r i o d 1 - j u m p i n g o n t h e b a n d w a g o n ; ( i ii ) th e y s w i t c h i n P e r i o d

    1 ; ( iv ) s w i t c h i n P e r i o d 2 e v e n i f o th e r s h a v e n o t s w i t c h e d i n P e r i o d 1 . T h e l a st

    s t r a t e g y is d o m i n a t e d b y s t r a t e g y ( ii i) . C o n s u m e r s o f l o w 0 u s e s t r a t e g y ( i ),

    c o n s u m e r s o f i n t e r m e d i a t e 0 u s e s t r a t e g y ( ii ), a n d c o n s u m e r s o f h i g h 0 u s e s t r a te g y

    ( ii i) . C o n s u m e r s w o u l d l ik e t o c o o r d i n a t e t h e m s e l v e s a n d s w i t c h i n th e f ir s t p e r i o d

    ( t h e r e b y g e t t i n g t h e b a n d w a g o n r o l l i n g ) b u t a r e u n a b l e t o d o s o , t h u s c r e a t i n g

    e x c e s s i n e r t i a . T h i s i n e r t i a c a n b e r e d u c e d t h r o u g h c o m m u n i c a t i o n a m o n g t h e

    c o n s u m e r s , t h o u g h c o n t r ac t s , th r o u g h c o o r d i n a t i o n i n c o m m i t t e e s o r t h r o u g h n e w

    p r o d u c t s p o n s o r s h i p a n d s p e c i a l i n t r o d u c t o r y p r i c in g . 35

    I n a s e q u e n t i a l s e tt i n g , p r e a n n o u n c e m e n t ( i .e . a n n o


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