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Network Externalities


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Title: Network Externalities

Network Externalities
Sometimes it helps if everyone uses the same
product or service. This may drive us towards
monopoly or standardization. Somehow, this
serious economic topic has gotten bogged down in
a lot of personalities. One problem is that
defining standards can both encourage the spread
of technology and limit the development of new
technology so when to impose standards is a
difficult practical choice.
Network externalities are not the same as
economies of scale
Economy of scale means that making many copies
of something is cheaper, per item, than making a
few. Network externalities means that there are
benefits if many people use the same thing. They
both may encourage monopolies, but they are
different. By the way, the phrase network
externalities was coined by Jeff Rohlfs, once at
Bell Labs.
Specific examples
Having the only tennis racket in town is useless.
The more people that own tennis rackets, the
more useful they are. It doesnt matter whether
its cheaper to make more rackets than fewer
rackets. This is a network externality. Manufactu
ring many copies of the same digital camera is
cheaper, per camera, than making only a few. It
doesnt matter whether people benefit from all
using the same camera. This is an economy of
Solitaire doesnt have any network externality.
You dont gain because other people are playing
it. Bridge does. Being the only bridge player in
town (at least until we had computer programs to
play against) is pointless and the more players
there are, the more useful it is for you to know
how to play bridge. In neither case is there any
economy of scale. By comparison, pong had
enormous economies of scale (the usual low cost
of duplicating software) and no network
externalities. Multiplayer games, on the other
hand, do have network externalities.
Ordinary externalities
In economics, the word externalities refers to
costs or benefits that fall outside the activity
that is being discussed. Since economists believe
that if all costs and benefits can be charged to
the activity that creates them, the market will
produce an optimal allocation of resources, they
view externalities as tending to produce
misallocations, and thus as undesirable.
Negative externalities
In the popular press, the most common use of
externalities is to talk about pollution.
Pollution is a negative externality a cost which
a business manages to push onto society as a
whole. If businesses had to pay for their own
pollution, then costs and activities would
reflect the right (or at least
market-determined) amount of pollution. There
are many references to this phenomenon. Few seem
to give real data.
Pollution cost
An EU study (Mike Holland, Paul Watkiss) gives as
an example that the cost of putting a ton of
sulfur dioxide into the air in Stuttgart is about
36,000 euros, representing the cost of extra
hospital admissions. If power plants in Stuttgart
are using high-sulfur coal, and not trying to
clean up their emissions, they save money buying
cheaper coal, but they push a cost onto society.
In the USA, burning low-sulfur coal costs
113/ton sulfur dioxide saved scrubbing costs
300/ton. So cleaning up power plants is a good
deal overall, but the power plant operator only
sees a cost.
Air pollution in China
The next two slides are almost unreadable. They
come from http// Th
ey show (1) years of life lost in areas of China
from air pollutants note that the population in
each square is very large, so the thousands of
years are divided over a great many people and
(2) the costs associated with a power plants
emissions, both health costs and decreases in
agricultural yields.
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Many other examples
There are many kinds of negative externalities,
some of which get beyond economics… Paper
companies dumping acid into rivers may destroy
the fishery in that river. Building a new house
congests the roads and may degrade the view from
existing houses. Smoking cigars may cause others
to feel that its too smelly to enjoy the
Positive externalities
There are also positive externalities. You might
do something which helps others, but not get any
of the financial benefit. For example, if you
keep your lawn neat, the value of your neighbors
house goes up slightly. You wont get any of
that increase when it is sold. Or if you take the
train to work, everyone else gets a little less
traffic again, this isnt reflected directly in
the price of your train ticket (although the
government may subsidize rail travel for that
Beekeepers get honey from beehives, and the bees
also pollinate the crops of the nearby farmers.
In 1952 this was quoted in an economics article
(by Meade) as an example of a positive
externality the farmers get their crops
pollinated as an external benefit of
honey-making. It appears that it was not until
1973 that Cheung published an article observing
that farmers pay beekeepers to move their hives
into orchards and fields. (See The Fable of the
Bees, J. Law Economics, in JSTOR). The extent
to which economists appear to be ignorant of the
real world is appalling.
Lighthouse (Edward Hopper)
since it is impossible that the ships at sea
which are benefited by a lighthouse, should be
made to pay a toll on the occasion of its use, no
one would build lighthouses from motives of
personal interest, unless indemnified and
rewarded from a compulsory levy made by the
state. John Stuart Mill. Paul Samuelson, in
his textbook, gives lighthouses as an example of
positive externalities. Ronald Coase, a
Nobel-prize winning economics, wrote a 1974
article pointing out that lighthouses in 18th
century England were privately owned. But (see
Bertrand, The Coasean analysis of lighthouse
financing myths and realities) the government
forced shipowners to pay for the lighthouses, and
the system was very inefficient.
Why these arguments?
These arguments are not really about beekeepers
and lighthouses. Paul Samuelsons textbook, the
most prestigious and common introductory
economics book, is considered too liberal by the
more free-market economics groups, and they thus
look for opportunities to attack him and his
book. Samuelson has tried to revise his book to
give more attention to a wider variety of
economic opinions, but hes never going to
satisfy the more extreme critics. (Anyway, hes
now 91 years old he was born in 1915).
Network externalities
Some externalities have to do with a need for
many people to share something. When you buy a
DVD player and some DVDs, you encourage an
industry, and thus more DVDs are put on the
market. When you throw out an 8-track tape
player, you discourage the industry, and if
enough people do that, no more 8-track tapes are
sold. In the early days of the telephone, you
could only phone up people who bought their
service from the same company. This doesnt work
out well pretty soon the companies must either
interconnect or merge.
If there are strong benefits for everyone to use
the same product, how do we know the product
will all work together? Returning to the
canonical example of tennis rackets, it isnt
helpful if one person has a tennis racket,
another has a badminton racket, and another has a
ping-pong racket. Standards can be established
either by committees or by the market. We can
all exchange email because of IETF standard RFC
822. (IETF Internet Engineering Task Force).
We use Powerpoint because of Microsofts market
When to standardize?
If we standardize too early, we may make a wrong
technology choice. If we standardize too late,
we may impede the development of a market. The
British chose early that railway track gauge
should be 4 ft 8.5 in. Today many think that it
was a mistake to use that gauge when the
carriages are 9 ft wide (10 ft or more in most of
the world) the Great Western tried 7 ft, but
lost out. (On the other construction is cheaper
with a smaller gauge). Today, failure to agree on
Sonys Blu-Ray vs. Toshibas H-D formats for the
next kind of DVD is holding up the market.
Beta, VHS, and Krugman
Paul Krugman pointed to the Beta-VHS controversy
as an example of choosing a standard too early
(path dependence). He argued that Beta was a
superior technology but once most people had VHS
players, most of the movies came out on VHS and
Beta disappeared. His critics point out that Beta
once outsold VHS, and that VHS recorded for
longer times, and thus Beta was not superior and
the market had chosen wisely. Again, this has
much more to do with Krugmans status as a
liberal columnist than with technology.
Krugman also pointed to the typewriter keyboard
as a mistake made early he suggested that a
different arrangement (the Dvorak keyboard)
would have let us all type faster. Again, critics
point out that no really good comparison shows
the Dvorak keyboard to be better QWERTY had
become a standard long before people did
experiments. (What psychologist today, do you
think, would want to run experiments on whether
light bulb sockets have the right diameter?)
Dvorak keyboard
Although there are no decent studies by modern
standards, perhaps it suffices to say that some
typing competitions banned the Dvorak keyboard as
unfair. On the other hand, people willing to do
text messaging on telephone pads have no business
complaining about QWERTY. (And a 93-year old
beat a 13-year at text messaging he used Morse
Being first
Pioneers are the guys with the arrows in their
backs It isnt always important to be first.
Its not just VHS overtaking Beta. There were
once more cars in the US driven by steam than by
internal combustion engines, and there were once
12-inch laser videodisks, and so on. In the
Internet, Lycos was once the leading search
engine, then it was AltaVista, and then it was
Google. Traditionally, companies like Sears,
Roebuck observed that most of the money is made
as a product moves from 5 adoption to 95
adoption, and they aimed at that growth, not the
stage which goes from 0 to 5.
Getting big
There are those who do try to get market share
early and hang on. The Japanese were known for
the strategy of market share first, profit later. lost money for years establishing
itself as the main source for online books,
driving Borders out of the market. The larger the
effect of network externalities, the more
important it is to be the first big player. And
depending on whether you can maintain control,
you may as a result get a big profit.
A great many web pages about network
externalities talk about the benefits of people
sharing a word processor or calendar or email
system and get involved in the Microsoft
antitrust issues. Needless to say, you can find
many pages arguing whether having only one
standard word processor is good for consumers
(because economies of scale reduce the price and
network externalities increase the benefit), or
bad for consumers (because Microsofts monopoly
position lets it raise prices for a bigger profit
than, say, Intel or Dell per sale). In todays
politics, people will defend unregulated monopoly
but they will not defend regulated monopoly.
The Microsoft Zune music player has 802.11
wireless, and if you are near someone else with a
Zune player, you can lend them a song for 3 days
or 3 plays. This is marketing for both Microsoft
and the music companies. Unless lots of people
buy the Zune, the feature is of little value you
have to be physically near the other
machine. Presumably as a result of pressure from
the recorded music companies, the person who
receives a loaned song can not then lend it out
again (unless they buy it).
So what does this mean for information? Are
there advantages to sharing the same information?
Besides the economy of scale in making many
copies, perhaps people are more likely to go into
a bookstore or library if they are confident they
will find the same things they saw advertised or
heard about. Isnt this just the long tail
discussion from the other side? Yes, as far as
content is concerned. But there are also
questions about systems, interfaces, etc. Would
it help if libraries shared borrowing facilities,
organization, and the like?
Once upon a time many major libraries had their
own classification systems. Eventually they all
joined either Dewey or LC. Mostly economy of
scale its cheaper to classify books only once
than to do it in each library. But also network
externality the users gain by not having to
learn a different shelving system in each
library, assuming that most of them will use
several different libraries in the course of
their studies. Could we imagine a major change to
either the Dewey or LC standards today?
Perhaps the most dominant network externality is
language. If you write a web page in Welsh or
Inuktitut, not many people can read it. If your
only audience is that community, you may be OK
with that. But if a general essay on physics or
Shakespeare was written in a less-common
language, its not likely to get
attention. Before telecommunications, this was
less of a problem if youre limited to
face-to-face conversation, and you happen to be
in Pond Inlet, Nunavut, Canada, you are better
off with Inuktitut. But now the Web may be
threatening not just the uses of Inuktitut, but
even languages like Danish or Greek. European
scientific journals, for example, are now
overwhelmingly in English.
Library users
If recommendation systems (social filtering) are
important, then library users will want to find
the same books in each library. If most library
users are remote, rather than local, the
advantages of gathering local resources may be
limited. Effectively, the switch to online means
that the user population is now some large,
geographically dispersed, and loosely coupled
group. Any advantages will come from membership
in very large external networks, not from small
ones. (If there were no long-distance calls, it
wouldnt matter if different cities had
incompatible phone companies).
Back to railway gauges
Isolated railway lines can pretty much use any
railway gauge (either track gauge or loading
gauge) that they want. But if they want to
interchange trains or cars with other railways,
they need to agree on the gauges. So originally,
the fact that British railways had 9-ft wide
carriages while European railways had 10.2-ft
wide wagons didnt matter. Then the Channel
Tunnel was dug, and its now inconvenient that
continental-size trains dont fit through British
stations. Britain is thinking of spending a lot
of money to partially fix this. Same problem with
info the Internet makes compatibility more
Libraries and externalities
There is some advantage to common catalog systems
across libraries, but whether they should share
books is less clear. If the long tail argument
is right, libraries should actually spend more
effort than they now do selecting materials
specifically for the community they serve. But
if everyone is going to move around and deal with
all libraries at once, then one big system is
going to have advantages. Im fairly pessimistic
I dont see why independent libraries should be
more viable than independent bookstores, or than
independent radio stations.