The Economics of Networks: Interview with N. Economides
Part 2

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

On Networked Industries and Market Structure
 

Q:	Is seems that when significant network externalities exist, there may be a natural trend towards monopoly or imperfect competition. What factors influence the path of market structure in network industries?

 
In all economic activity history plays some role. For example, the AT&T trademark assures consumers of a certain level of competence and customer service. Similarly, when two operating systems of the same functionality, quality, and efficiency are offered at the same price, consumers will tend to buy the OS for which there are more applications. Microsoft and other OS sellers spend a significant amount of money and effort to make sure that independent software companies write applications for their operating system. An OS seller may also keep its price low to guarantee wide acceptance of its OS so that independent software companies anticipate a large market and write software for this OS. The market outcome depends on historical market share, but most importantly, it depends on the pricing strategies of the competitors and the availability of software compatible with each OS. The winner is often the company that is willing to sell at a low price for a long time to gain market share and reap the externalities. The loser is typically the firm that sells at a high price, receives short term profits, but loses in the long run. Being first is useful, but persistence and the correct pricing policy are more important.

In summary, we have the paradoxical situation where the winning firm (that has high market share) is at the same time the company that sells at a low price. Sacrifices in price pay off in higher market share, and market share in more valuable when the industry has network externalities, since higher sales signify higher value. In this process, consumers benefit from the low market price.

I have shown in theoretical models (see "Compatibility and Market Structure for Network Goods") that monopoly (or a very concentrated industry) can be a natural free-entry equilibrium in a market where there are very strong externalities. In such a market, at a natural equilibrium, the leading firm can have three times the market share than the second firm, the second largest firm can have three times the market share of the third firm, and so on. Moreover, sometimes it is better for society to have a more concentrated industry because then society realizes the benefits of high network externalities of the leading platform.
 
 

Q:	From a welfare maximizing point of view, should we prefer one market structure over another?

 
My paper "Compatibility and Market Structure for Network Goods" shows that sometimes a more concentrated market results in higher social welfare than a less concentrated market. A judgement has to be based on the very specific features of a market.
 
 

Q:	It seems difficult to forecast the financial success of a producer of a good subject to network externalities. Do network externalities imply a "winner take all" industry?

 
A network consists of many complementary components. The use of a number of components is required to produce a final service. Often the components of the network have their own markets. A firm can be most successful if it can monopolize the market for one crucial component while markets for complementary components are competitive. The failure of analysts to distinguish between promising and not promising ventures arises from a failure to adequately define the market for the final service or from a failure to identify the extent of market power in each of the markets for the components.
 
 

Q:	You have, in past research, focused on interesting issues raised by networks such as technical compatibility and standards, interconnection, pricing, etc. In what direction is your current and future research headed?

 
I am currently doing research in telecommunications and on network industries in general. The latest papers are on the "Economics of Networks" web site.

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

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