Lecture Managerial economics - Chapter 8: Network effect

Lecture Managerial economics - Chapter 8 presents contents: Motivation for network effect, network externality, source for network externalities, winner takes all, similar rationale: learning curve, lock-in,... Inviting you to refer.

Week 8

Network Effect

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Motivation for Network Effect

AOL, Yahoo, MSN and Google offer free instant messaging software.

• Clearly, not a profit maximizing strategy at least in the short run.

• Why would they set price = $0 and maximize the market share?

Network Externality

Network externality

• if the number of consumers using the product

increases the product’s demand

–similar to positive externality

–higher sales push demand curve out

• Examples?

– DVD players

– video game systems (PS2)

– Email

– Fax machine

– ?

3

Source for Network Externalities?

need for a standard

• Same platform to exchange “data”

– MS Word software

– DVD players

– fax machines

– language

• industry standard for other products

– operating systems

– which side to drive on

– 110 voltage

If there’s a need for a standard, how many products (standards) will survive?

Winner Takes All

How many products will survive in a market?

• Theoretically ONE, a natural monopoly

–empirically, more than 1 can survive because of different consumer tastes

–but we expect 1 dominant product/standard

Implications of Network Externality for business strategy

• there might be a first-mover advantage

–a race for market share

–become the standard

–being the standard implies switching costs for your

customers

• justification for sacrificing short term profits in favor of long

Similar Rationale: Learning Curve

Learning Curve:

• Production cost gets lower over time b/c of experience

from producing

Implications for business strategy?

• Lower price and produce more in the short run

–Sacrifice short run profit

• In long run, it can become the lowest cost provider

What is the difference between learning curve and NE?

• Learning curve : supply side effect, cost

• NE : demand side effect, standard

Suppose

• There are 2 products: I (inferior) and S (superior)

• There’s a significant network externality with these

products

If the inferior product entered the market first,

• It may become a monopoly

• The superior product gets no market share

• We are stuck with inferior product

Outcome is not optimal for the society = Lock in

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Examples of Lock-In (?)

Possible lock-ins (?)

• VHS v BetaMax

• DOS v Macintosh

• QWERTY v Dvorak keyboards

• 110 voltage v 220 voltage (?)

• Other example?

Lock-in is only a theoretical prediction

• Real evidence are hard to find

• The above examples are not conclusive evidence for

lock-ins

Entrant with the Superior Product

Attempt to unlock the Market

• The firm producing superior product will fight for the

market share

Conditions to unlock

• greater quality difference ⇒ easier to overcome

• many potential buyers ⇒ easier to increase market share Business Strategy for the new entrant

• Product differentiation

• merger, if possible

• temporary price cuts

• further improvements in quality

• lower switching cost for existing customers

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Business Strategy for the Incumbent

If you are incumbent with inferior product, what

is your business strategy?

• Given rival’s strategy, the only way to sustain the market share is to improve the quality

• Invest in R&D

– Once invested, it will be sunk cost

– Once sunk, this cost will not affect future decision

– This is a leverage against new entry that must bear sunk cost in future

• Lower price

– Doesn’t work well

Empirical Evidence for Lock-ins

Survival of the fittest

• If the new product is superior, it will prevail eventually

• The incumbent constantly improves its quality

Empirical Evidence

• Very hard to find a true example of lock-in

– The incumbent that survived must have some

advantage

• It may happen to standards related with custom, culture – language (?)

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Unlocking Examples Nintendo v SONY PlayStation

Word Perfect v MS Word

Quicken v MS Money (?)

Other examples?

• ?

Network Externality

• Individual’s demand depends on others’ consumption

Lock-In

• Conditions

– Significant network externality

– Inferior product was the first mover

• Result

– stuck with the inferior product

Empirical evidence

• History tells superior product eventually overtakes the

market

• Evidence for lock-in is rare

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Regulation, Public goods

Three categories of government's role in the economy:

1 Macroeconomic - Using fiscal (Congress) and monetary policy

(Federal Reserve) to achieve macroeconomic goals of stabilizing the economy and promoting low unemployment, full output,

stable prices, stabilize the business cycles, prevent recessions, etc.

2 Microeconomic - Provide public goods (national defense, FBI,

police protection, fire departments, roads and highways, court system, patents, etc.) and regulate the economy (FDA, FTC,

DOJ, FAA, zoning, etc.)

3 Distributive - Redistribute income to reduce income

inequality, improve the welfare of the poor, provide medical care (Medicare, Medicaid, VA hospitals), provide retirement income (Social Security).

The microeconomic role of Gov.

1) improve upon potential market failures,

inefficient production or consumption.

2) provide the "optimal" amount of public goods

and services that cannot be "provided" by the

private sector.

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Market failures and regulation

Market Failure due to monopoly

Government responses to monopoly practices (Enforce antitrust laws):

1> Breaking up monopoly Examples: a> Standard Oil in 1911, 90%

market share for oil & b> AT&T in 1982 for 100% of the telephone service.

2> Preventing Monopolies from Arising

3> Preventing Mergers that Reduce Competition The government

blocked the mergers of: a> Staples and Office Depot & b> Rite-Aid and Revco.

4> Preventing Collusion a> Ivy League universities were forced to

stop meeting and sharing information on tuition increases, faculty salaries and financial aid policies b> Archer Daniels Midland

pleaded guilty to price fixing for food additives in the U.S with

international competitors and it paid a $100m fine, the largest

antitrust fine in history.

Market failures and regulation

Bottom line: Antitrust laws are complex, somewhat vague,

confusing and controversial

Controversy: "Chicago School" (laissez-faire) hands off

approach vs pragmatic approach to antitrust enforcement

Pragmatic Approach was more prevalent during Clinton's

administration, using more of a case-by-case approach

E.g., the Office Depot-Staples merger was challenged even

though the combined firm would only have had 4% of the national office supply market

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Market failure due to externalities

Externalities (positive or negative) are secondary effects that have an

impact on the well-being of nonconsenting parties.

Pollution: negative externality (spillover cost) Literacy/Education:

positive externality (spillover benefit).

Solution: Government action could improve upon the market outcome

by: a) regulating the amount of pollution and b) requiring

mandatory attendance in school and providing public education

Remedying Externalities

Solutions for externalities (negative) include: 1) government taxes,

standards or permits for externalities like pollution, or 2) monetary payments between the affected parties by either bargaining

(negotiation) or by court decisions

Transferable Emissions Permits is another regulatory approach.

Subsidizing Positive Externalities , Promoting R&D and Patent system, and Regulatory Reform

Market failure due to imperfect

information

In reality there could be many cases of incomplete, misleading

or inaccurate information about consumer products or

services, leading to a potential role for government

intervention to correct for market inefficiencies

Example: Regulations for car companies including CAFE

(corporate average fuel economy) standards

Benefit-cost analysis (BCA) is a method of making decisions

and evaluating public projects, programs, regulations,

etc Any public decision can be guided by BCA

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