This paper analyzes the economics of industries where network externalities are significant. In such industries, firms have strong incentives to adhere to common technical compatibility standards, so that they reap the network externalities of the whole group. However, a firm also benefits from producing an incompatible product thereby increasing its horizontal product differentiation. We show how competition balances these opposing incentives. We find that market equilibria often exhibit extreme disparities in sales, output prices, and profits across firms, despite no inherent differences in the firms' production technologies. This may explain the frequent domination of network industries by one or two firms. We also find that the presence of network externalities dramatically affects conventional welfare analysis, as total surplus in markets where these externalities are strong is highest under monopoly and declines with entry of additional firms.

Key words: networks, network externalities, coalition structures, technical standards, compatibility

JEL Classification: L1, D4

^* Stern School of Business, New York, NY 10012, tel. (212) 998-0864, fax (212) 995-4218, e-mail: neconomi@stern.nyu.edu, fflyer@stern.nyu.edu, www: http://www.stern.nyu.edu/networks/

^** We thank Ken Arrow, Tim Brennan, Bob Hall, Charlie Himmelberg, Brian Kahin, Ed Lazear, Pino Lopomo, Roger Noll, Roy Radner, John Roberts, Sherwin Rosen, Myles Shaver, Phillip Strahan, John Sutton, Tim Van Zandt, Michael Waldman, Larry White, participants of the "Interoperability and the Economics of Information Infrastructure" conference, the 1997 Telecommunications Policy Research Conference, the Industrial Organization and the Information Systems seminars at the Stern School of Business, and seminars at the University of Chicago, Princeton, Stanford, and UC Irvine for their comments and suggestions.

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