Gensheng Liu Operations and Management Science Department Carlson School of Management University of Minnesota

Transcription

1 The Economics of Industries With Network Externalities: A Review of The Economics of Network Industries (Oz Shy, London, UK: Cambridge University Press, 2001)3 rd Version Gensheng Liu Operations and Management Science Department Carlson School of Management University of Minnesota gliu@csom.umn.edu The economics of networks applies to a wide variety of industries and electronic commerce settings that have become increasingly influential and relevant to the world that we live in. Shapiro and Varian (1999) state that the fundamental economic characteristic of networks is their positive feedback loops. This is caused by the combination of demand-side economies of scale and supply-side economies of scale. The value of connecting to a network depends on the number of other people already connected to the network. Much research has been done in the economics of networks, but seldom have researchers tried to reveal the economic theories underlying different network industries. Oz Shy fills this gap with his new book, The Economics of Network Industries (Cambridge, UK: Cambridge University Press, 2001). In this book, the author first introduces the basic concepts associated with the economics of networks. He then provides an economic analysis of the following network industries: hardware, software and telecommunications; broadcasting; markets for information; banks and financial services; and the travel industry. The book conveys the essential features of how strategic interactions between firms are affected by network activities. It also covers social interactions and their influence on consumers choices of the products and services they buy. Table 1 shows the main characteristics of the network industries, as well as their relevance in an e-commerce context. Shy argues that, due to these characteristics, these markets cannot function competitively and will be characterized by dominant leaders capturing most of the market share. Consequently, competitive equilibria do not exist in these network industries. Although market failures exist, Shy still believes that government

2 intervention is, for the most part, unnecessary. He gives several examples to show that government intervention tends to make things even worse. Table 1 about here Shy fails to identify how government intervention may sometimes benefit network industries. For example, the U.S. government s support of the electronics industry accelerated the invention of the transistor, and it enhanced the competitiveness of the U.S. electronics hardware industry. Additionally, without government support around the world, the Internet could not have grown so rapidly in the past decade. Kalakota and Whinston (1996) show that governments play a crucial role in promoting the development of the Information Superhighway. Shy looks only at the negative side of government intervention, however. Instead of considering government intervention as a means for reducing market failures, Shy argues that the competence of firms and individuals in network industries reduces market failures. The contributions of this book are threefold. First, it attempt to reveal the economic rules underlying network industries. It is impressive that even social interactions and some other social phenomena are included in his discussion. Some of these topics are: conformity and vanity, the economics of entertainment places, languages, religious affiliations, attorneys and lawsuits, and international time coordination. Although the discussion of these topics is by no means thorough, it significantly expands the scope of network industries beyond the usual high-tech industries. It also reminds us that many other industries may exhibit network characteristics and thus can be analyzed as network industries Second, in his analysis, Shy provides a framework to analyze network industries, which can also be applied in the context of electronic commerce. For example, in financial services, there are many new network services such as electronic billing, electronic money, Internetbased banking services, and e-brokerage services. Since all of these services have the principal characteristics of networks, they can be analyzed as network industries in the framework Shy provides. Indeed, much of the industry structure and technological solutions that are associated with the innovations of the Internet and electronic commerce exhibit such features. Third, Shy not only considers the profit of manufacturers, but also considers the welfare of consumers, seeking to find the socially optimal outcomes for the various markets. For example, he reveals that in the computer hardware market, industry profits are always higher 2

3 when firms choose compatibility over incompatibility, but consumers are worse off under compatibility. This is because firms manage to extract much higher rents under compatibility, and these high rents far exceed consumers gains in utility resulting from compatibility. Few analysts take the welfare of both manufacturers and consumers into account. For instance, while analyzing the oligopoly competition under compatibility in network industries, Economides (1996) based his equilibrium concept solely on the profit of two competitive firms, with no consideration of the welfare of consumers. A notable feature of this book is that although it is very analytical and covers a wide scope of issues, it does not use rely on mathematics to convey its findings. Instead, Shy uses intuition from game theory and other logical reasoning approaches. Apparently he believes that there is no requirement for mathematical complexity to support the presentation of relevant theory. This makes the book accessible to readers with different backgrounds. The principal shortcoming of Shy s book is that he tends to use overly simplistic models in his analysis. While analyzing the adoption of the electronic cash card, for example, Shy considers the following factors: time savings, probability of the card loss, and probability of magnetic errors. He concludes that as soon as buyers do not have to worry about magnetic errors, they will substitute electronic cash card for notes and coins. This is pretty simplistic though. By contrast, Au and Kauffman (2001) examine the adoption of electronic bill presentment and payment technology in a context that involves four stakeholders: billers, bill consolidators, banks, and consumers. Network externalities play a significant role in their model. Their findings are much richer and more applicable: not only do they find that billers are more likely to adopt the existing technology early, but they also find that depending on expected benefits and costs, anticipation of new technologies might cause billers to wait. 3

4 References List Au, Y. A., and Kauffman, R. J. (2001) Should We Wait? Network Externalities, Compatibility, and Electronic Billing Adoption, Journal of Management Information Systems, 18 (2), Fall: pp Economides, N. (1996) The Economics of Networks, International Journal of Industrial Organization, 14 (6), October: pp Kalakota, R., and Whinston, A. B. (1996) Frontiers of Electronic Commerce, Reading, MA: Addison-Wesley Publishers. Shapiro, C., and Varian, H. R. (1999) Information Rules: A Strategic Guide to the Network Economy, Boston, MA: Harvard Business School Press. 4

5 Table 1. Main Characteristics of the Network Industries Main Characteristics Brief Explanation E-Commerce Examples Complementarity, compatibility and standards Consumption externalities Switching costs and lock-in Significant supplyside economies of scale To function together as complements, products must be compatible and operate on the same standard. Each additional user will increase the value of the network for all other users. Depending on the cost of switching to a different product, customers may have different degrees of lock-in. With a very high fixed sunk cost and negligible marginal cost, the more you produce, the lower your average cost of production. XML and HTML as standards for Web page markup and data representation; ANSI X12 and EDIFACT as standards for EDI. The more banks that adopt electronic billing systems, the more customers want to sign up, and vice versa. Changing from American Online to another ISP requires changing one s address, which raises the switching cost. Digital products, such as software packages and information archives, are costly to develop, but it cost nothing to download and transmit them via the Internet. 5