Chapter 16 Flashcards
Network externalities
the situation whereby the benefit a consumer derives from owning a product increases when the number of other consumers increase
direct network externalities
arise when the different buyers form a network of users who communicate with each other
indirect network externalities
when the utility of a product increases with the greater availability of compatible complementary products
chicken-and-egg problem
consumer’s valuation depends on his expectation of how many other consumers will make a purchase. if the network externality is sufficiently strong, then the demand curve may look like the thick line in the graph. from a pricing point of view, the seller is faced with a chicken-and-egg problem
consumer expectations
example: if consumer expects the restaurant to be empty, then it will be empty, and vice-versa
fulfilled-expectations equilibrium
if everyone expects that a z fraction of the population will purchase the product, then this expectation is in turn fulfilled by people’s behavior
network effect may imply multiple demand levels for a given price. which value takes place depends on consumer’s expectations regarding network size
full restaurant and empty restaurant might both be an equilibrium
critical mass
point at which a growing company becomes self-sustaining, and no longer needs additional investment to remain economically viable (point q’)
unstable equilibrium
critical mass and adoption of innovations
the concept of critical mass is particularly important to understand adoption of innovations subject to network effects. The overall adoption paths depends on how the chicken-and-egg equilibrium multiplicity unfolds
excess inertia
although the new technology equilibrium is Pareto superior, both players stick to the old technology
reluctance to switch to a new socially more desirable technology due to the existing network effects of the old technology (installed base)
excess momentum
opposite of excess inertia
occurs when a new technology replaces the old technology, even though it yielded more utility to consumers and producers
bandwagon/(domino/snowball) effect
common phenomenon when network externalities are strong
tendency of people to take certain actions or arrive at a conclusion primarily because other people are doing so
sometimes preferences are such that society would be better off if no switch to a new technology were to take place, but industry dynamics make the switch inevitable
excess inertia <=> excess momentum
network externalities may imply excess inertia, whereby a new technology is not adopted even though it would be in most people’s interest to do so. But network externalities may also imply excess momentum, whereby a switch to a new technology occurs even though most people would prefer it not to happen
the economy is an ergodic system
historical events may have an effect, but that effect vanishes as time goes by
Network externalities may imply multiple equilibria, whereby an industry locks in to one technology or another. Which technology ends up being chosen depends to a great extent on the actions of early adopters (path dependent). The eventual winner need not be the superior or most-preferred technology.
if a compatibility agreement is reached, then both firms…
…earn duopoly profits
If no compatibility agreement is reached, then whichever firm won the standards battle earns…
…monopoly profits
Scenario 1: firms would be better off if they had reached an agreement
when reaching no agreement, the firms enter a standardisation battle which leads to spending resources to attract consumers. In the end, the firm who has spent the most wins, gets the monopoly profit.
- > only a compensation of all the firm has spent
- > both firms have a net payoff of zero
Scenario 2: firms would be better off choosing incompatibility
In a series of events the firm has no control over, if they agree on compatibility, they will get duopoly profits. If they do not agree and an exogenous event decides who gets the monopoly profits, the average profits will be 50%π_m
-> it is better to be a monopolist half of the time than a duopolist all of the time
If standards competition is very intense, then firms prefer (1). If product market competition is very intense, then firms prefer (2).
- compatibility
2. incompatibility
Splintering
The main reason for the failure of innovative products might be that consumers become very confused over which standard to choose, thus preferring not to choose at all.
connected to excess inertia
backward compatibility strategy
a related strategic choice of compatibility of a firm’s technology with previous versions of its technology
can create a barrier to entry
two-sided market
when both buyers and sellers meet to exchange a product or service, creating both bids to buy and offers (asks) to sell
Standarization
the process of developing, promoting and possibly mandating standards-based and compatible technologies and processes within a given industry
The benefits from standardizing must be weighed against the costs of less competition and product variety
