The Economics of Networks: Footnotes The Economics of Networks


1. Plenary session address, E.A.R.I.E. conference, Chania, Greece, September 1994. I thank Larry White for helpful comments.

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2. The literature on networks is so extensive that it is futile to attempt to cover it. This paper discusses only some issues that arise in networks and attempts to point out areas in which further research is necessary.

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3. AS and BS can also be components of substitute phone calls ASC and BSC.

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4. The 1994 spectrum auction will allow for a large two-way paging network.

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5. In this network, we may identify end-nodes, such as Ai and Bj, end-links, such as AiSA and SBBj, the interface or gateway SASB, and switches SA and SB.

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6. See Sharkey (1993) for an excellent survey.

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7. See Baumol, Panzar and Willig (1982).

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8. It is already eliminated in some parts of the United Kingdom, where cable TV operators offer telephone service at significantly lower prices than British Telecom.

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9. These significant changes in costs and the convergence of communications services open an number of policy questions on pricing, unbundling, deregulation, and possibly mandated segmentation in this sector. It is possible that ownership breakup of local and long distance lines is no longer necessary to improve competition. For example, European Union policy mandates open competition by 1998 in any part of the telecommunications network, but does not advocate vertical fragmentation of the existing integrated national monopolies; see the Bangemann Report. The reduction in costs and the elimination of natural monopoly in many services may make it possible for this policy to lead the industry to competition.

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10. Another important network, the airline network, faces significant change in Europe. Airlines have not benefitted from significant cost reductions and technological change; the present reform is just the abolition by the European Union of the antiquated regime of national airline monopolies, and its replacement by a more competitive environment.

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11. This property of two-way networks was pointed out in telecommunications networks by Rohlfs (1974) in a very early paper on network externalities. See also Oren and Smith (1981).

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12. For a more detailed discussion of networks in Finance see Economides (1993a). Economides and Schwartz (1995) discuss how to set up electronic call markets that bunch transactions and execute them all at once. Call markets have inherently higher liquidity because they take advantage of network externalities in exchange. Thus, transaction costs are lower in call markets. Economides (1994a) and Economides and Heisler (1994) discuss how to increase liquidity in call markets. The survey of institutional investors reported by Economides and Schwartz (1994) find that many traders who work in the present continuous market environment would be willing to wait a number of hours for execution of their orders if they can save in transaction costs, including bid-ask spreads. Thus, the time is right for the establishment of call markets in parallel operation with the continuous market.

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13. The increase of utility in expectation due to market thickness was pointed out by Economides and Siow (1988), and earlier and in less formal terms by Garbade and Silber (1976a,b), (1979). The effects are similar to those of search models as in Diamond (1982, 1984).

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14. In this formulation n and ne are normalized so that they represent market shares rather than absolute quantities.

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15. It is possible to have other shapes of the fulfilled expectations demand. In general p(n,n) is quasiconcave under weak conditions on the distribution of preferences and the network externality function. Then, if none of the three causes mentioned above are not present, the fulfilled expectations demand is downward sloping.

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16. A monopolist unable to influence expectations will clearly produce less than a monopolist able to influence expectations.

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17. See Economides (1984), Yi and Shin (1992a), and Yi and Shin (1992b).

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18. Economides and Flyer (1994) examine the incentives for coalition formation around compatibility standards.

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19. Standard 1 is an equilibrium if a > e, b > d. Similarly, standard 2 is an equilibrium if g > c, h > f.

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20. Matutes and Regibeau (1988) and Economides (1989) find that compatibility is always the firms' choice because they assume a locational setting with uniform distribution of consumers in space that results in equal own-product and hybrid demands at equal prices. The exposition here follows the more general framework of Economides (1988), (1991).

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21. These results also hold when firms can price discriminate between buyers who buy the pure combination AiBi and buyers who buy only one component from firm i. Thus, firms practice mixed bundling. See Matutes and Regibeau (1992) and Economides (1993c).

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22. See Economides (1988) for a discussion of Cournot's result, and Economides and Salop (1992) for an extension of the result to (parallel) vertical integration among two pairs of vertically-related firms.

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23. Economides (1991a, p. 52).

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24. See also Encaoua et al. (1992) for a discussion of the coordination of the timing of different legs of airport transportation.

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25. Consumers also receive lower surplus in comparison to vertically integrated monopoly.

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26. The reliability of the network, measured by the percentage of time that the network is in operation, or by the probability of a successful connection, is measured by the product of the respective reliabilities of the components (another non-linear function).

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27. This result is dependent on the linear structure of the demand system, and may not hold for any demand structure.

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28. Church and Gandal (1992a) find that sometimes firms prefer foreclosure, but their model does not allow for a vertical price squeeze.

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29. This result is in contrast to Bonnano and Vickers (1988) because of the absence of two-part contracts in Economides and Woroch (1992).

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30. This is changing for some customers through the existence of Competitive Access Providers, who directly compete with the local telephone company for large customers, and the potential for competition by Cable companies.

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31. Kahn and Taylor (1994) have very similar views.

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32. Armstrong and Doyle (1994) relax this assumption.

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33. See Arthur (1988), (1989), David (1985). David argues that the QWERTY keyboard was adopted mainly because it appeared first while the DVORAK keyboard was superior. This is disputed by Liebowitz and Margolis (1990).

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34. See Katz and Shapiro (1992) for a different view arguing for excess momentum (which they call insufficient friction).

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35. See also Farrell and Saloner (1988) for mechanisms to achieve coordination, and Farrell and Saloner (1985) for a discussion of network product sponsorship.

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