The Economics of Networks: Interview with N. Economides
Part 1

Intro | Part 1: On Networks | Part 2: On Networked Industries and Market Structure | Part3: On Policy and Microsoft

On networks in general
 

Q:	First it would be nice to clarify a couple of definitions. What are the defining characteristics of a network?

 
Networks are composed of links that connect nodes. It is inherent in the structure of a network that many components of a network are required for the provision of a typical service. Thus, network components are complementary to each other. Typically a number of components are required to produce a service. These components may be produced by different networks. For example, a telephone call from New York City to San Francisco starts over the circuits of New York Telephone (Bell Atlantic) until it reaches a local switch in New York City, wherefrom it is picked up and carried by a long distance company (such as AT&T) to a similar switch of Pacific Bell (SBC) in San Francisco. Then Pacific Bell carries it to the San Francisco subscriber. So, the call requires the use of the circuits of New York Telephone, AT&T, and PacBell, and (at least) two switches. These are all complementary components of the network. See the example of the information superhighway.

Typical examples of networks are telecommunications networks (fixed and wireless), fax networks, credit card networks, ATM networks, railroads, electricity networks, etc. Network features, including the existence of "network externalities" (see below), are discussed in more detail in "The Economics of Networks".
 

Q:	And what are network externalities?

 
Networks exhibit positive consumption and production externalities. A positive consumption externality (or "network externality") signifies the fact that the value of a unit of the good increases with the expected number of units to be sold.
 

Q:	How do network externalities arise? Please give examples.

 
Network externalities can arise directly or indirectly. For example, in a typical telecommunications network with n subscribers, the addition of the (n+1)^th subscriber allows for 2n additional types of calls to be made (from the new subscriber to all old subscribers and vice versa). Clearly, the number of additional calls (2n) that become possible when the (n+1)^th customer is added increases with the size of the network n. If each of the calls has a fixed value, it is clear that the value of adding one more customer increases as the network size (n) increases. This is an example of a direct network externality.

Network externalities arise directly in telecommunications and fax networks as well as in the internet, financial exchange (stock market), credit card, and ATM networks. Network externalities also arise in "virtual networks" where two complementary components are required to make a valuable good or service. Typical examples of virtual networks are the combination of compatible software and hardware, or the combination of a computer operating system ("OS") and applications software that run under the OS. In these cases, the value of an operating system is higher when there is a large number of applications that can run under it. Conversely, an application has higher value if it runs on a widely-accepted OS. The combination of these effects makes the value that a consumer receives from an OS higher when the sales of the OS are higher. Similar reasoning shows the existence of network externalities in any good that requires a distribution or a repair network, or, more generally, requires a complementary good.
 
 

Q:	It seems that many industries exhibit network externalities. Where are network externalities crucial?

 
Some products have no value if there is no network. For example, a fax machine is useless unless there exists another fax machine to communicate with. In contrast, a computer program, say WordPerfect, has value even if no one else bought it. Its value increases with the number of users (because this enhances the availability of in-house technical support and the availability of secretaries trained in WordPerfect), so there are network externalities, but this may not be the most important determining factor of the value of the program.
 
 

Q:	Do you think that the importance of networked goods and network industries in the economy is growing?

 
Network industries and network goods are a very significant part of the US and world economy since they encompass key industries, including telecommunications, computers, electricity, and transportation. These industries, especially computers and telecommunications are growing very fast. They are driven by the steep reductions in the costs of integrated circuits, the progressive digitization of many functions, and the wider use of programmable multi-purpose devices. Network industries are expected to continue growing at a faster pace than the US economy.
 
 

Q:	How will the workings of the economy begin to change in response to the increasing expansion of network industries?

 
Some of the changes are already here. The World Wide Web has completely transformed the information industry. Information retrieval and information gathering and mining have become much easier. Multiparty communication, chat, conferencing etc., although feasible earlier, became widely available through the web. From a social point of view, the World Wide Web is especially useful in bringing together individuals around the world that share a common interest. The WWW also facilitates trade. Although electronic commerce is still at its infancy, distribution of books, music CDs, software, as well as securities trading have taken off with significant success. Interactive selling is just starting. Customers already have the ability of get live simultaneous offers on automobile loans by different firms on the web. There is an increasing competitive pressure for better price and higher efficiency.

As more information becomes available to the average household, the deciphering of what is important and relevant becomes increasingly difficult. The need for services that make selections for users (or, alternatively, facilitate users' search) is ever more important. I expect that some of the most profitable businesses on the web will be those that guide customers to information. There is much to be done in this direction. Despite the good efforts of Yahoo, there are still no authoritative "yellow pages" on the web.

Changes in network industries require more flexibility by industry. The response of some traditional industry players to change is sometimes far from in tune with the times. For example, the demand for telecommunications services is currently much higher than ever envisioned, partly because of internet use. But as more households demand a second or third telephone line, traditional local telephone companies (for example, Pacific Bell in California) complain that callers stay too long on line. Companies have to adjust to the times!

In the telecommunications sector, the Telecommunications Act of 1996 was been a brave attempt by Congress to bring the legal framework of the telecommunications industry closer to a natural competitive environment as shaped by rapid technological change. A key provision of the 1996 Act was the facilitation of entry in the local market, which is presently dominated by the local telephone companies that emerged from the 1984 breakup of AT&T, and by GTE. Each of these companies is a monopolist in its local market. Unfortunately, over two years after the passing of the 1996 Act, armies of lawyers of the incumbent monopolists have fought against entry in the local market, and very little entry has been realized, to the great detriment of consumers.

Intro | Part 1: On Networks | Part 2: On Networked Industries and Market Structure | Part 3: On Policy and Microsoft

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