Network externality is also known as network effect. It is defined as a change of benefit a user derives from a good or service when other users who use the same kind of good or service changes (Gottinger 2003). There is direct and indirect network externality. Direct network externalities are what come out of other users adopting the same system. Examples of direct network externalities include telephone systems and computing plat forms like electronic commerce. On the other hand indirect network externality is the result of many people using the same system. It is when the devices become cheaper with the increment of the number of users. It is in insurance company where the network externality has an important role to play in electronic commerce. Network size is an important issue that is brought forward by network effects.
In positive network externalities there is need of more people that bring about more interaction. There are also negative network effects that are got from the resource limits. The automobile is one of the examples of negative effects that illustrates that threshold limits can be available. This results to the number of people decreasing the value of a network if there is lack of provision of additional resources. There is an exclusion value in some networks.
Provider complacency is also an example of negative network effect (http://www.si.umich.edu/IGD/tutorials/netexternalities/t1s4.htm). Competition is an important factor in every firm because absence of competitors makes a provider to restrict resources. It may also result to increase of fee or may cause creation of an environment that does not benefit the user. If there is presence of competition users would prefer changing to another firm instead of complaining. This would make firms to improve their products and services to a higher standard.
The scope of relevant network is determined by the usage of products from different firms together. There is always a question of communication if users can consult users of another firm. If more than one firm’s system is compatible, the number of users to the systems constitutes to the network that is more appropriate. If there is incompatibility whichever system is appropriate to the users. In the markets of hardware and software, there is confusion of whether software that is designed for a specific hardware may be run in another type of hardware. If both hardwares can share the same software then they are termed as compatible where relevant network is set of users of the hardware. It is in personal computers where CPM operating system is produced to allow several brands of computers to use similar programs. The quadraphonic audios are different in that records designed for one type of player cannot be used in another type of player with a different quadraphonic technology. In this case the relevant network for specific equipment has set of brands that use the same type of technology but not entire market.
Sometimes the relevant network is set of brands that use the same parts of servicing skills. In automobile for example if a model has been made according to the users specifications, the owner might find a thinner and more expensive service system of his or her a model (Hope, 2000). This type of network reduces the users’ will of paying for the model. Little work has been done in this area of network externalities regardless of the markets significance. There is a need of extension of study of network externality in regard to oligopolistic setting. A simple oligopoly model should be developed to analyze the markets. Firstly there is a study of the effects brought forward by the consumption externalities in the market where there is competition. Market equilibriums also well studied. Consumers are supposed to form some expectations according to the size of competing networks if there is existence of network externalities.
Consumption externalities should give rise to the demand side of economies of scale. This should vary with the users’ expectations which results expectations existing for a specific cost and utility function. Some of the expectations are that only one firm produces a certain output. Other expectations are that there are a several firms in them market producing outputs. This kind equlibria makes it clear that consumer’ expectations of the seller being dominant, they will be willing to pay more for that firm’s product where the firm becomes dominant. Firms have a right to choose whether to manufacture compatible products. This then determines whether the entire market sales are relevant ones in the evaluation the consumer externalities. This leaves a question if the firms will provide proper incentives that help in producing compatible goods or the services. For a firm to develop, it is important for it to avoid compatibility even if the welfare is increased by the move to compatibility. This is only important large existing networks. The small networks or those that have weak reputations would prefer compatibility even if the social costs outweigh the benefits.
There are some cases where there are no income effects and the customer works hard to maximize their surplus. Here a customer for example may decide to buy one brand and might purchase one or no unit of any provided unit. The number of agents that joins the network for a certain product determines the consumers’ surplus that is derived from buying a unit that is related to that product. The individual’s consumption benefits are also determined by the future size of the relevant network if the goods are durable. Here then the consumers prefer placing their purchase decision on the expected network sizes. To capture this feature, consumers are supposed to make purchase decisions before the release of the actual network sizes. There is timing that is then done where the consumers should firstly form expectations about the size of the network where each firm is associated. Then the firm takes the consumers expectations as provided where set of prices are generated. Consumers then later make their purchase decisions where they compare reservation prices with the prices the firm has set. Here then it is clear that consumers expectations are fulfilled.
Two firms with positive sales with the same product should have their prices adjusted to the network size. Prices of their products should be equal. These firms have production costs that are in form of fixed costs. The fixed costs do not have an effect on the markets equilibrium and are equal to zero (http://ecommerce.hostip.info/pages/785/Network-Externalities.html). The cost of compatibility should be fixed through out. The compatible products are of the same margin as the incompatible products in terms of production. There exists too much competition.
During competition there is direct competition where alike products compete against each other. This is also known as brand competition. Some companies introduces innovation where they add a new product to their line so that other companies produce the same and then the competition starts. There is also indirect competition where substitutes of a certain products compete. A competition within the company is also another type of competition that exists.
The existence of network externality brings about some problems that the decisions of the firm and the consumers. Firm may decide to adopt technology while the customers decide to select the product which results to the arising of some problems to this area. The firms’ decision of adopting the technology is the same as product compatibility (Gabel & Weiman, 2005). The market may fail to throw up compatibility because it is very expensive. The firm then considers compatibility as a strategic variable if the technology choices are left to the market. Markets may fail to maximize social welfare due to compatibility and standardization. The standardization can be made more difficult by the converters where they allow consumers to break through the barriers that separate one network from another. This is done by reducing the social cost due to failure of standardizing. This makes it easier for the consumers to follow separate technological paths.
Compatibility is the assumption of homogenous products. Network is the only dimension of product differentiation. A firm should decide on the quality of the product and should also consider providing a two-way converter or not that is used to make products compatible (http://www.utdallas.edu/~liebowit/palgrave/network.html). It has been noted that in regard to equilibrium the firm choose different qualities of products but still keep them compatible. Incompatible networks are not common in today’s world. Most of the firms differentiate their products vertically but not horizontally. This kind of equilibrium does not exist in all values of the coefficient of network externality. What is in existence is the mixed strategy equilibrium. This entails vertically differentiated but mutually incompatible networks co-exist with a positive probability only.
Network externality is purposely generated in the market for systems. This comes as a result of complemantarity of component parts of a system. If a network good is made compatible to another commodity it then generates higher benefits it the consumer. There are some ways that are used to achieve compatibility. One of the ways is through standardization while as the other one is provision of a two-way converter. Standardized products are based on the same technological platform. Provision of a two-way converter enables products based on different technological platforms to work together.
Network size is the mass of consumers in a network that is covered by the industry if the systems produced by different firms are compatible (DIANE publishing, 2002). On the other hand the network size is the mass of consumers where the firm covers if the systems produced are incompatible. There is also the existence of partial compatibility where by a software can run in two hardware’s but not all can be run on both brands of hardware. In a case like this it is believed that the products are perfectly compatible or perfectly incompatible.
The network externalities throw a challenge to the economists’ traditional use of deceasing returns (http://www.si.umich.edu/IGD/tutorials/netexternalities/t1s4.htm). They grant primacy to economies to scale. Positive network externalities have impacts that are related to those of conventional firm-level economies of scale. Competitors who have a larger market share have an advantage over those with smaller market share. This is brought by the fact that the networks effects operate only on the compatible networks. Network effects are then proven not to be in general sufficient for natural monopoly type results as indicated by Shy O. (2001). Network effects would then be found to be sufficient for the outcome of natural monopoly if the average production are falling or are constant. If the production costs show decreasing returns and these deceasing returns outweighs the network effects, then there is no implication of monopoly and it will make it easy to compete incompatible network.
The economists have proven that economy can operate in a range decreasing returns. The new technology is believed to takeover a larger share of the economy which will facilitate the increase of the shares with the increase of the returns. The increase of the returns will bring about a different understanding. If a natural monopoly dominates the choice of the network provided then only one standard that will remain in the market. The newer literature do not believe that the natural monopolist is who dominates a market will be as efficient as any other producer. This was in existence in the traditional world.
Less existence of network effects and increasing returns do not in any way lead to the choice of inferior technology. Some of the assumptions made are that network effects differ across the alternative networks. It is also assumed that the network type that offers greatest surplus when the participation is large is the same one that operates on the vice versa.
Network effects model features particular results (Baumol, 2000). There are formal models whose outcome follows from assumptions. These assumptions are responsible for the outcome and are believed to be unappealingly restrictive. There are some limitations in network effects model. These include the assumptions of constant marginal cost and network value functions that sometimes rise without limit. Increase in scale can become of no effect when the network size reaches a point where additional participation does not provide additional value to participants. This will further bring about the possibility of multiple networks competing on an even basis.
There is another limitation that entails the assumption that consumers are the same in their valuations of competing networks. Since more than one taste is allowed, it becomes important for the competing networks to coexist with one another even if they give out natural monopoly traits. Another restriction is about the symmetric value that got by a consumer when another consumer joins a network.
It is possible that network effects might be greatly limited than the assumptions made. A common example is spreadsheets and word processors that need just identical software so that they can be perfectly compatible with each other. Compatibility is considered to be important to employees who are working in the same firm but not to the rest world because there is a need of multiple networks to survive (Bekkers, 2001). This also applies to large firms where compatibility is important within but not outside the firm. There is no natural monopoly to producers whose consumers are large firms. This is because there might be little or no network advantage in selling to multiple firms.
In conclusion network externality is a change of benefit a user derives from a good or service when other users who use the same kind of good or service changes. There is direct and indirect network externality. Direct network externalities are what come out of other users adopting the same system. There are positive and negative network effects. In positive network externalities there is need of more people that bring about more interaction. Negative network effects are got from the resource limits. Competition is an important factor in every firm because absence of competitors makes a provider to restrict resources. It may also result to increase of fee or may cause creation of an environment that does not benefit the user. Most of the firms differentiate their products vertically but not horizontally. . This entails vertically differentiated but mutually incompatible networks co-exist with a positive probability only.
Network size is the mass of consumers in a network that is covered by the industry if the systems produced by different firms are compatible. On the other hand the network size is the mass of consumers where the firm covers if the systems produced are incompatible. The economists have proven that economy can operate in a range decreasing returns. The new technology is believed to takeover a larger share of the economy which will facilitate the increase of the shares with the increase of the returns. It is possible that network effects might be greatly limited than the assumptions made. There is another limitation that involves the assumption that consumers are the same in their valuations of competing networks. Compatibility is considered to be important to employees who are working in the same firm but not to the rest world because there is a need of multiple networks to survive. Compatibility of products should be avoided to avoid competition in network effects.
Baumol W.J. (2000). Network Effects: Competition, Texas, American Enterprise Institute.
Bekkers R. (2001). Compatibility, New York, Artech House.
DIANE publishing, (2002) Network Externality, New York, DIANE Publishing
Gabel D. & Weiman F.D. (2005). Networks Competition, New York, Springer
Gottinger H. (2003). Network Externality, California, Routledge.
Hope E. (2000). Network Externality Compatibility, California’s, Routledge
Shy O. (2001). Network Effects, New York, Cambridge University Press.