Systems Competition and Network Effects

Katz & Shapiro

A dominant network based on a near universal standard can internalize a great deal of
system externality to the benefits of network users and can persist even in the face of
technically superior competing networks.

For many products, one consumer’s utility from using the products is not dependent on
how many other consumers also use them. For other products, one’s choice of which
products to buy and use critically depends on how many other consumers also use them.
These products thus generate external effects that must be taken into account in consumer
choice. One class of these products either shares the same universal standards or must be
used in large networks. For example, computer networks and telecommunications
systems are typical of these products. Three issues are involved in consumer choice (and
thus producer choice) among systems; namely, expectations, coordination, and
compatibility.

In a communications network, the network is more useful the more users use it. In the
case of a fax machine communications system, if each consumer expects no other
consumer will purchase a fax machine, then no one will purchase it. On the other hand, if
each consumer expects that a large number of other consumers are going to purchase fax
machines, then many would purchase fax machines. This then is the pure expectation
issue.

But hardware alone does not make a network work unless there is enough software to
justify the purchase of the hardware. For example, a firm contemplating whether to
develop and release a new architecture of microprocessor, for example, must know
whether software will be provided to work on the new microprocessor. Such coordination
between producers of complementary products compounds the difficulty of consumer
choice in adopting networked products.

Once the network achieves a threshold size, its continued expansion is built on the
emergence of compatible products. The more compatible products there are, the bigger
the network grows. And the bigger the network grows, the more compatible and cheaper
products will be offered. This process of positive feedback is fueled by the increasing
extent to which external benefits of individual adoptions can be internalized among users
of the network. Thus, once a network has established its dominant position, any new
products that are not compatible with this dominant network will be rejected no matter
how technically superior they might be. Any new products incompatible with the
dominant system must compete not with individual products of the dominant system, but
with all the internalized benefits of an established system.

While internalized network externality is formidable, it is not unbreakable. One

possibility is that the sponsor of a competing network can indirectly commit itself to a
price path involving “competitive” second-period prices by opening the market to
independent suppliers of complementary products. Another way is to commit a major
asset to guarantee the viability of a competing system. Casual observation suggests that
one reason that the IBM PC (a new system challenging the established CPM system) was
so successful is that consumers expected the product to succeed since it was backed by
the reputation of IBM!

References:

• Katz, M.L. & C. Shapiro. 1994. “Systems Competition and Network Effects,”
Journal of Economic Perspectives 8 (2): 93-115.

Source:

http://opus1journal.org/articles/article.asp?docID=151

Term quasi-public good Definition: A good that is easy to keep nonpayers from
consuming, but use of the good by one person does not prevent use by others. Also
termed a near-public good,the trick with a quasi-public good is that it is easy to keep
people away, and thus you can charge them a price for consuming, but there is no real
good reason to do so. From an efficiency view, the more people who consume a quasi-
public good, the better off society. This mixture of nearly unlimited benefits and the
ability to charge a price means that some quasi-public goods are sold through markets
and others are provided by government. For efficiency's sake, none should be sold
through markets.

We have seen that a public good is one for which it is not practical to exclude consumers.
A pure public good is one where it is impossible to exclude some consumers - if the good
is provided for one person, it is provided for all. Law and order would be an example.
However, if the consumption of a good can be excluded, however impractical, then the
market could in theory provide a price mechanism for it. Street lighting, or perhaps,
lighthouses, would be an example. Ships approaching within a certain radius of a
lighthouse could send out an identifying radar signal. The ship owners could be charged
for getting close to the lighthouse. Ships who do not wish to be charged could avoid the
lighthouse. For this reason it is not impossible to charge for the provision of lighthouses,
though still impractical. Such goods are therefore not pure public goods, and are
consequently called quasi-public goods.
 Information as a Quasi-Public Good

The difficulties in providing efficient incentives for the production of information

products through property rights lead some people to say that information is a public
good. But this is inexact.

The definition of of a public good in economics is narrow. In economic theory, "a

public good" has two characteristics:

1) The cost of providing the good does not depend on the number of consumers who
benefit from it.

2) It is not feasible to exclude those who do not pay from the benefit of the good.

Economists have traditionally argued that, because of these characteristics, public goods
will not be supplied by a profit oriented market economy. If they are to be supplied at all,
government must supply them.

We may use Adam Smith's example of the lighthouse to illustrate this concept. The
lighthouse exists to warn passing ships of a dangerous shoal or coast. All ships that come
within sight of it benefit from it. The cost of maintaining the lighthouse is a fixed cost,
and does not depend on the number of ships that benefit from it. It would, at best, be
difficult to intercept ships as they come within range of the lighthouse and demand that
they pay a toll for using it -- but even if it were done, it would do no good. The ships
would know their position simply because they were asked to pay, and would correct
their course to avoid the danger -- getting the benefit without paying! So the lighthouse
fulfills the definition of a public good.

Is it an information product? Yes. A light per se may not be considered a symbol, but in
the context of a map (which is symbolic) and a route plan, the light takes on a (symbolic)
meaning it would not have out of context. Moreover, some lighthouses flash in specific
on-and-off patterns, to make it easier to identify them. This is symbolic in the strictest
sense, and the light is the medium, not the information product.

Well, then: are information products, in general, public goods? The answer is no. They
are not public goods because an information good cannot be transfered without at the
same time transferring the medium. In the case of the lighthouse, the medium -- light -- is
itself a public good. But in other cases, such as books, the medium (paper) is not a public
good. And publishers are to some extent able to collect from those who benefit from the
book. At the very least the publishers can collect from the first purchaser of the book.
Since the information product can only be sold in conjunction with some medium, the
information product is a public good only if the medium is a public good.
But there is an important middle ground between public goods and purely private goods.
We might define purely private goods by negating the two characteristics of public goods
given above: For purely private goods,

1a) The cost of providing the good increases at least proportionately to the number who
benefit from it.

2a) It is always feasible to exclude from the benefit of the good those who do not pay for
it.

An example of a pure private good is a potato. If I eat the potato, you cannot, and it will
cost twice as much (or more) to double the production of potatos. Also, the farmer can
demand that I pay for the potato before I take it home -- so, unless I steal it, I can benefit
from it only if I pay. Pure private goods are at the other end of the spectrum from pure
public goods.

The intermediate category we may call "quasi-public goods," since they share the
characteristics of public goods to some extent. For quasi-public goods,

1b) The cost of providing the good increases less than proportionately to the number who
benefit from it.

2b) There are some difficulties in excluding those who do not pay from the benefit of the
good.

These two conditions are relative. Some quasi-public goods will come nearer the public
end of the spectrum, in that costs increase much less the proportionately than the number
of beneficiaries and the difficulty of excluding non-payers is quite considerable. Other
quasi-public goods will come nearer the purely private end of the spectrum, in that costs
increase almost in proportion to the number of beneficiaries and the difficulty of
excluding non-payers is slight. The nearer the good is to the public end of the spectrum,
the greater its "degree of publicness" is. The greater its "degree of publicness" is, the
greater the incentive problem is.

It seems clear that information products typically are not public goods but are quasi-
public goods. Their degree of publicness varies widely, though, and changes in
technology (media) can change the degree of publicness. It seems likely that the trend of
technology has been to increase their degree of publicness. Nevertheless, most
information products continue to be supplied by profit-oriented private business. Thus,
unlike pure public goods, government provision will not be necessary in most cases, and
may make things worse in some cases.

Source: http://faculty.lebow.drexel.edu/McCainR//top/prin/txt/infoch/inf11.html