Network Externalities

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  • Topic: Network effect, Externality, Monopolistic competition
  • Pages : 5 (1759 words )
  • Download(s) : 96
  • Published : October 13, 2010
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1. Introduction
With the rapid development of new communications technology and network technology, some industries such as information industry show significant network externality characteristics. Network externality has been defined as "a change in the benefit, or surplus, that an agent derives from a good when the number of other agent consuming the same kind of good changes" (Liebowitz & Margolis, 1996). In other words, the product will be more valuable if more people use it. For example, the telephone becomes increasingly valuable since people have greater use of it. Therefore, the network externality has essentially a positive feedback effect. This paper aims to explain the concept of network externalities and apply this theory into real-life examples.

In the first part, it provides a literature review for network externalities. The second part analyses of direct network effect, and the third part gives indirect network effect. An example is given in the fourth part and finally the paper draws a main conclusion. 2. Network Externalities – Literature Review

Katz and Shapiro (1994) explain the theory of network externalities and how consumers behave when they face choices. The literature examines how expectations, coordination, and compatibility affect three basic clusters of decisions: technology adoption decisions, product selection decisions and compatibility decisions. Expectations mean that rational buyers form the components that they will be buying in the future in terms of availability, price and quality (Katz & Shapiro, 1994). Coordination is defined as ‘system markets pose challenges for coordination among firms and consumers’ (Katz & Shapiro, 1994). Compatibility is defined as ‘a component designed to work in one system also work in another system’ (Katz & Shapiro, 1994). The article indicates that communication network has direct network effects, while the hardware/software paradigm involves indirect network effects. By using examples, they prove that the communication network is an expectation issue. After that, the article use the hardware/software paradigm to explain how the coordination between producers and complementary products affects consumers’ decision-making in adopting network products, which will be discussed in detail later in this paper. Furthermore, the article mentions that the appearance of compatible products depends on whether the size of network is large enough. Moreover, under the circumstance, compatible products have absolute advantage and the incompatible products will be rejected by the network. 3. Direct Network Externalities

Katz and Shapiro (1994) mentioned the communication networks with their direct network externalities. Examples of communication networks are e-mail and telephone users or other means that people can reach the others or exchange information with each other. One user will find it more valuable as others use them as well. In such case, the user values private benefits exceeding the cost of joining a network. For instance, a user purchases a mobile phone in order to have a faster, more convenient and direct communication with people who also own a mobile phone. As more and more people do so for the same purpose, a network of mobile grows gradually. From the mobile firms’ and the telecommunication industry’s point of view, since the demand of using a mobile increases, both have to improve their products and services in order to meet the consumers’ expectations.

The initial aim of using a mobile is to communicate. Nevertheless, consumers’ expectations and firms’ market performance determine the mobile industry as well as the providers growing fast nowadays, which exhibit positive adoption externalities (Katz and Shapiro, 1994). Namely, mobile firms pursue to design a more user-friendly or a multifunction product that fits in different segments by taking the consumers’ and the market’s responses into account. The positive feedback also...
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