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Encyclopedia of Law & Economics - 0760 NETWORK EXTERNALITIES



William H. Page
Mississippi College, School of Law
John E. Lopatka
University of South Carolina, School of Law
© Copyright 1997 William H. Page and John E. Lopatka



1. Introduction

A. Types of Network Externality

2. Direct Externalities

3. Indirect Externalities

4. Network Effects versus Network Externalities

B. Effect of Externalities on Network Size

5. Physical Networks/Direct Externalities

6. Virtual Networks/Indirect Externalities

C. Competition Among Networks

7. Tipping and Lock-In

8. Criticism of the Tipping Scenario

D. Compatibility and Standardization Among Network Goods

9. Compatibility and Standardization Among Network Goods

E. Policy Implications

10. Policy Implications: General Remark

11. Antitrust: Monopolization

12. Antitrust: Horizontal and Vertical Agreements

13. Intellectual Protection for Proprietary Standards

14. Contract Terms and Other Norms

Bibliography on Network Externalities (0760)

Other References



A network exists when a product's value to the user increases as the number ofusers of the product grows. Each new user of the product derives privatebenefits, but also confers external benefits (network externalities) on existingusers. Network externalities may cause markets to fail. Networks may not reachoptimal size, because users fail to take account of external benefits. Markets inwhich incompatible standards compete may "tip" in the direction of a standardthat gains an early advantage, even if that standard is objectively inferior.Suppliers of network goods may compete to become the de facto standard ormay attempt to make their products compatible. The theory of networkexternalities has been applied in numerous legal areas including antitrust(monopolization and cooperative standard-setting); intellectual property (thescope of protection for dominant software programs); and corporate law (theselection of contract terms).

JEL classification: K00

Keywords: Increasing Returns, Positive Feedback, Lock-In, Standardization

1. Introduction

The subject of network externalities has become popular in the economic andlegal literature since the mid-1980s. The fundamental idea is that the act ofjoining a network confers a benefit on all other participants in the network.According to proponents, this seemingly simple phenomenon stronglyinfluences competitive strategies and market outcomes in network markets.Network externalities can, for example, influence consumers' decisions whetherto adopt a new technology and producers' decisions whether to standardize theirproducts. Ultimately, the literature suggests, network externalities can causemarkets to fail: "equilibrium may not exist, or multiple equilibria may exist" and"the fundamental theorems of welfare economics may not apply" (Katz &Shapiro, 1994, p. 94). Networks may not reach optimal size, because purchasersdo not take account of social benefits of their purchases, and markets mayconverge on an inferior standard that effectively excludes better products.

The theory of network externalities is well developed, especially for such anew field of inquiry. Its policy implications are less clear. Some economists claimthat the inefficiencies associated with network externalities are common in someimportant markets, including computer hardware and software, transportation,and telecommunications. And some argue that network externalities justifychanges in the law of antitrust, corporations, economic regulation, andintellectual property. Some of the proposed policy changes would involvegreater government intervention in the market, some would involve less. Otherscholars suggest that courts and policymakers should be cautious in relying onnetwork externalities. They argue that the theoretical market failures associatedwith network externalities would only occur under rare conditions. They alsochallenge the empirical evidence that network externalities have actuallythwarted the adoption of better technologies. Any real market failures in networkmarkets, they argue, probably stem from familiar economic phenomena (likenatural monopoly) that are better analyzed using conventional tools. Even if themarket has failed, government intervention is inappropriate because networkexternalities cannot be identified in practice or government action is likely to bemore costly than any benefits it may produce. In the following discussion, wewill address both theoretical and policy issues, trying wherever possible to keepthem distinct.

A. Types of Network Externality

The users of certain products can be thought of as forming networks, eitherbecause they are physically connected or because they have close marketrelationships. A network externality is a benefit conferred on users of such aproduct by another's purchase of the product. (A purchase may also imposeexternal costs, but the literature focusses primarily on the sources andconsequences of external benefits, or positive consumption externalities.) Someanalysts distinguish between direct externalites, exemplified by communicationsnetworks, and indirect externalities, exemplified by the "hardware/softwareparadigm" (Katz & Shapiro, 1985, 1994; Church & Gandal, 1992b). Note that thedistinction between direct and indirect externalities refers to the source of benefitto participants in the network, not necessarily to the magnitude of the networkeffect.

2. Direct Externalities

Direct externalities typically occur in a physical, two-way communicationsnetwork (Rohlfs, 1974). My purchase of a fax machine, for example, directlybenefits existing fax machine owners, who now have an additional person withwhom they may communicate. If there are n fax machines in the network, eachowner has n(n-1) potential interlocutors; an additional fax machine adds 2n(total) potential communications within the system, and thus enhances the valueof membership, assuming that each owner may at some point wish tocommunicate with every other owner (Economides, 1996). Similar reasoningapplies to telephones and internet access software, each of which expands thenumber of people who can communicate over a physical network. Users of thenetwork thus receive increasing returns in consumption. (Notice that directbenefits do not accrue to users of a one-way physical network, like paging orelectric power transmission, because the existing users of the networked goodsmay not interact with new users any more easily than those who are not on thenetwork (Economides & White, 1994; Economides, 1996).) Producers of networkgoods may also receive increasing returns to scale in production, at least up tosome critical mass.

The "positive feedback effect" (Arthur, 1989, 1990) of increased network sizemakes the larger network that much more attractive to new purchasers, and thegoods that permit access to the network that much more valuable. The value ofthe good to the purchaser also depends on the purchaser's expectations aboutthe future size of the network. The demand for a fax machine is thus a functionnot only of the price of the product, but also of the expected size of the networkto which the fax machine will be connected. This last point resolves the apparentparadox that, despite the downward slope of the demand curve, the marginalpurchase of a good can yield a higher value than inframarginal goods: the valuecontributed by the expected size of the network offsets the reduction in valuefrom the purchase of a marginal unit (Economides, 1996).

Direct network externalities might arise even in the absence of a physicalnetwork. Those who speak a language, for example, constitute a network. Thevalue of knowing a language depends in part on how many others speak it. Astudent's decision to learn a language is influenced by the expected size of thenetwork of speakers; and the student's learning the language directly benefitsother speakers. Similarly, the value to an individual of a particular wordprocessing program, say WordPerfect, likely will depend in part on the numberof others who select WordPerfect and with whom the individual expects toexchange files. This effect is diminished to the extent that conversion betweenprograms is possible, but, so long as conversion is imperfect or costly, the effectpersists.

3. Indirect Externalities

Economists have also identified indirect externalities in the "network" of usersof systems of compatible devices, even if the devices owned by different usersare not physically connected. A system can be any combination of a durablegood and associated goods or services that perform some desired function. Katzand Shapiro (1994) illustrate this type of system with the hardware/softwareparadigm, which includes not only computer hardware and software, but manyother product combinations, including cameras and film, phonographs andrecords, and television sets and programming. More broadly, a typewriterkeyboard could be considered hardware, and the capability and experience ofusing that keyboard could be considered software. Owners of compatiblehardware and software systems constitute a "virtual network." (Katz & Shapiro,1985, 1994; Arthur, 1989, 1990). At the extreme, any combination ofcomplementary products can be described as a system, and those who purchasethe system can be said to form a virtual network. Thus, a cappuccino machine,a coffee grinder, espresso coffee beans, and milk form a system, and those whodrink home-made cappuccino form a network.

Indirect externalities can arise in these markets only when, as is typical, thecomponents are purchased at different times. For example, applications softwareprograms are often purchased at various times over the useful life of a computer.In these circumstances, adoption of the hardware by one purchaser confersexternal benefits on other users of the same hardware, because it expands theinstalled base of the hardware, stimulating demand for compatible software.Suppliers may therefore take advantage of scale economies and provide morevarieties of software. The availability of more diverse and inexpensive softwareenhances the value of the existing users' hardware. These indirect benefitsstemming from strong complementarities are said to cause positive feedback inmuch the same way as direct benefits of expanded communication in physicalnetworks.

Indirect network externalities may arise in many contexts. Participants inphysical networks, both one-way and two-way, may receive indirect externalbenefits, if the increased size of the network results in more options and betterservice. Traders on a financial exchange may also receive indirect benefits fromthe array of services provided by the exchange (Economides, 1993a, 1996). Andusers of Discover cards benefit when more people carry Discover cards, becausemore merchants will accept a widely-adopted card (Evans & Schmalensee, 1996).

4. Network Effects versus Network Externalities

Liebowitz and Margolis (1994, 1995a) distinguish network externalities fromnetwork effects. A network effect exists when "the net value of an action . . . isaffected by the number of agents taking equivalent actions" (Liebowitz &Margolis 1994, p. 135). Network effects, so defined, are ubiquitous in theeconomy. Purchases of a good by one group of consumers may bid up its priceand thereby affect other consumers of that good as well as consumers ofcomplementary and substitute products. Liebowitz and Margolis point out thateconomists at one time misinterpreted these interactions as inefficiencies, butnow recognize them to be pecuniary external economies and diseconomies,which the price system internalizes as wealth transfers between, say, purchasersand suppliers. Liebowitz and Margolis (1994, p. 135) would limit the term networkexternality to those specific network effects in which "the equilibrium exhibitsunexploited gains from trade regarding network participation." Networkexternalities, so defined, do cause market failure, but are far less common thannetwork effects generally.

Liebowitz and Margolis (1995a) accept the distinction between direct andindirect network effects, but argue that they are fundamentally different in theirconsequences for efficiency. They recognize that direct network effects inphysical networks may (in limited circumstances) be true externalities. But theychallenge the notion that indirect network externalities arise whenevercomplementary goods become more plentiful and cheaper as the number of usersof the related product increases. They contend that much of what the literaturecalls indirect network externalities are merely positive pecuniary externalities thatresult in wealth transfers.

These theoretical points lead to very different policy conclusions. If the priceof complementary goods decreases as a network grows because rents aretransferred from input suppliers or producers to consumers, the market does notfail, and no state-sponsored remediation is necessary. If instead price falls dueto positive technological externalities, remediation may be required, but onlybecause of a conventional market failure in an upstream or downstream market,not network externalities.

Katz and Shapiro (1994), leading scholars in the field, have adopted thedistinction between network effects and network externalities in theory, thoughthey disagree in its application, and generally argue that true networkexternalities are more common than Liebowitz and Margolis suggest. Otherscholars continue to use the term network externalities to encompass all networkeffects. (Economides, 1996; Klausner, 1995).

B. Effect of Externalities on Network Size

5. Physical Networks/Direct Externalities

The existence of positive network externalities in adoption of a technology in aphysical network implies that the private marginal benefit of acquiring a networktechnology is lower than the social benefit. In deciding whether to buy anetwork good, the individual compares the price only with his private benefit,not the benefit that his purchase confers on other users. Consequently, theequilibrium size of a physical network under perfect competition, with directnetwork externalities, may be smaller than the social optimum (Katz & Shapiro1994; Economides 1996).

The size of a physical network is also affected by consumer expectations.Because information about other potential purchasers' future actions is alwaysimperfect, consumers' expectations may result in a nonoptimal network size. Forexample, if all consumers expect no one else to purchase, then the network sizewill be zero, even if all consumers would benefit by joining the network; if allexpect everyone to purchase, the size will be large (Katz & Shapiro 1994). Theimportance of consumer expectations gives producers an incentive to convinceconsumers through a variety of practices that their networks will attract manyusers.

Some physical networks may be owned by a single firm. Firms that own anetwork may use their property rights to internalize consumption externalities.This result is most apparent in entirely internal networks. Fax machines, forexample, faced an initial externality problem in that purchasers had no incentiveto buy one unless others did also. If there were a high enough degree ofuncertainty, the market might not have developed at all. But large firmsapparently had enough incentives to purchase fax machines for purely internalcommunications to create a critical mass (Katz & Shapiro 1994, p. 97, n.4).

A single firm's ownership or sponsorship of a physical network withindividual subscribers can also internalize network externalities. Consumersurplus is maximized if the sum of marginal private and social benefits of apurchaser equals marginal cost (Liebowitz & Margolis 1994; Katz & Shapiro,1994). Liebowitz and Margolis argue that ownership of such a network canusually solve the problem of a sub-optimal network size that flows from directnetwork externalities. The owner will set access prices that reflect the fact thatadditional users provide benefits to all other users. If marginal costs are assumedto increase, a network can reach an optimal size. Liebowitz and Margolis believethat the assumption of increasing marginal cost, typical to economic models, isappropriate here because economies of scale are exhaustible for many networkcommodities. In these circumstances, more than one network can coexist, socompetition is possible. If, on the other hand, economies of scale areinexhaustible, the market is a natural monopoly, which may be inefficient, but notbecause of something unique to the network character of the good.

Suppose that ownership of the network does imply a monopoly. Economidesand Himmelberg (1995) argue that the incentive of the monopolist to restrictoutput overwhelms its incentive in increase consumer demand by influencingexpectations about network size. The resulting monopoly equilibrium is at alower network size than under competition. Katz & Shapiro (1994) argue that, ifa monopolist charges a single access fee above marginal cost, external benefitswill not be internalized. But price discrimination "may well allow the network tointernalize the adoption externalities: for example by setting access fees at orbelow cost and earning profits on usage fees" (id. at 101). The network ownerthus addresses the problem of buyer expectations about the future size of thenetwork.

Liebowitz and Margolis (1994) recognize that not all networks that generatedirect network externalities can be owned. For example, the network of speakersof Esperanto is not ownable and so may fail due to direct network externalities.But other market mechanisms may minimize any social cost in such cases.Intermediary organizations may, for example, facilitate communication amonggroups within the population. Network effects can also be internalized by thedirect interaction of participants. For example, computer programmers workingon a common project can agree to adopt the same language. These interactionswill tend to internalize potential externalities when transactions are easy.Liebowitz and Margolis believe, therefore, that network externalities will notoften result in a suboptimal size of a network, and to the extent that a networkis inefficiently small, the reason can be traced to the conventional market failureassociated with natural monopoly.

6. Virtual Networks/Indirect Externalities

The analysis of the effect of indirect externalities on the size of virtual networksis somewhat different. In these markets, externalities may arise because of thedurable nature of the hardware component in the system. The purchaser ofhardware knows he will be "locked in" to the product for a time, because the costof switching to different hardware will be substantial. (On the effects ofswitching costs, see Klemperer, 1987a, 1987b, 1989). Consumers then may beuncertain about the future availability and price of software for the product. Ifthis uncertainty can be addressed, then the network externality problemdisappears. If, for example, all of the components of the system are competitivelysupplied by firms with U-shaped average costs, the market will reach an efficientcompetitive equilibrium. The market is indistinguishable from any competitivemarket with complementary products (Katz & Shapiro, 1994). Note that thisoutcome differs from the inefficient outcome in physical network markets undercompetition discussed in the previous section.

Katz and Shapiro (1994) argue that network externalities can arise if hardwareis supplied competitively at marginal cost, but differentiated software is providedat a price above marginal cost by firms subject to scale economies. Apparentlyresponding to Liebowitz and Margolis, Katz and Shapiro (p. 100) state that "ifall goods were priced at marginal cost, these network externalities would bemerely be pecuniary externalities, and market equilibrium in hardware/softwaremarkets would be efficient." If, however, software is not priced at marginal cost,a sub-optimal variety of software may result or software may be produced at aninefficiently high cost, and the resulting networks may be smaller than optimalbecause the marginal social benefit of additional sales is greater than the privatebenefit to the purchaser. In such circumstances, Katz and Shapiro argue, asubsidy to hardware suppliers (or software suppliers) can increase consumerwelfare by expanding the supply and variety of software. Liebowitz and Margolispresumably would respond that the subsidy in this case is (theoretically)justified because of imperfect competition in software, rather than because ofany indirect network externality.

If a monopolist supplies both hardware and software, consumers may fearthat, once they are locked in to the durable good, the monopolist will exploitthem by increasing prices of the software. (Farrell & Shapiro, 1988; Shapiro &Teece, 1994; Katz & Shapiro, 1994). Sponsorship arrangements by themonopolist may provide a solution. Thus, network externalities can be avoidedif the seller can somehow commit to software prices in advance of purchase. Ifsuch commitment is possible, consumers would have no reason to fear lock-inspecifically. They would, of course, be subject to monopoly pricing (eithersingle-price or discriminatory), but any inefficiency would then be attributableto the monopoly, not to network externalities. (Katz & Shapiro, 1985, 1994).

The monopolist may attempt in various ways to approximate a commitmentto future supply of compatible goods at prices consumers expect to pay. It may,for example, attempt to guarantee a competitive supply of compatible software,even inviting competitive firms to enter the market (Economides, 1996; Farrell &Gallini, 1988; Katz & Shapiro, 1994). It may also adopt a policy of leasinghardware, thereby assuring that customers would not be locked in, were it toraise software prices. Or it might engage in "penetration pricing" of hardware,which would mean that, although consumers may pay high software prices, theywill be compensated by lower hardware prices. Finally, it may rely on itsreputation as a bond securing purchasers against exploitation (Katz & Shapiro,1994). If it were to exploit purchasers, it would damage its ability to sell latergenerations of its hardware.

C. Competition Among Networks

7. Tipping and Lock-In

One of the most striking consequences of network externalities is their effect onthe nature of competition between sellers of products embodying different,incompatible standards. The literature cites many examples: VHS and Betastandards for VCRs; phonographs and compact disc players; conventionalversus high-definition television; and so forth. In such markets, networkexternalities may favor the market's adoption of a single seller's product as thede facto standard, such as VHS rather than Beta as a videotaping format. Incorresponding theoretical models, one technology gets an early advantage (forwhatever reason), and positive feedback of the larger network size leads newusers to adopt that technology. It is suggested that the first mover in markets forinformation-based software receive continuously increasing returns to scale,reinforcing early successes and aggravating early defeats (Arthur, 1989, 1990,1994, 1996). Ultimately, competing technology leaves the market. A market thatsettles on a single standard is said to have "tipped."

In other markets, network externalities and scale economies may beexhausted at a smaller network size, so that the market can accommodate morethan one network. Moreover, consumers' heterogeneous preferences can resultin multiple standards, such as the IBM-PC and the McIntosh computer(Liebowitz & Margolis, 1995a; Katz & Shapiro, 1994, p. 106). Firms, therefore,might prefer to promote their own incompatible networks regardless of theresulting size. Or each firm might prefer its own standard, yet prefer compatibilitywith a rival's standard if only one standard can prevail.

The tendency of network markets to tip leads to particularly intensecompetition early in the market's existence (Farrell & Shapiro 1988). Competitorsmay employ aggressive strategies like "penetration pricing" -- in some instancesgiving the product away -- in order to become the de facto standard. Katz andShapiro (1994, p. 107) observe that in such cases firms are "bidding for futuremonopoly profits". After achieving dominance, the firm may recoup some or allof the expenses it incurred in the early competition. In such cases, what appearsto be monopoly profit earned by the firm in later stages of production is actuallyrecovery of the earlier expenditures. Another possibility is that a firm with anearly lead may have an incentive to deter new entry by low pricing in order tobuild on its advantage (Farrell & Saloner 1986a).

One implication of the network externalities literature is that the market maysettle on a good with a lower social valuation. The literature cites numerousexamples: the QWERTY typewriter keyboard (David, 1985); VHS and Betavideocassette formats (Arthur, 1990); and AM stereo (Besen & Johnson, 1986).Proponents of network externalities point out that a good's value to the userdepends upon its inherent benefit (the value of the good to the purchaser evenif no one else adopted it) plus its network benefit. The network benefits increasewith the size of the network. Initial adopters will primarily take account of thegood's (apparent) inherent benefit to them. If that inherent benefit is greater forgood A than for good B, the initial adopters will choose A. As the size ofnetwork increases, it becomes still more advantageous to choose A over B, andall subsequent adopters will do so. But suppose that, although B offers lowerinherent benefits, its network benefits increase at a higher rate than those ofgood A, and at some network size actually exceed those of A. In theory, B wouldoffer greater social benefits if it were adopted by the market as a whole; but themarket nevertheless chooses A (Farrell & Saloner 1986b; Klausner, 1995). Katzand Shapiro (1994, p. 106) state that "standardizing on a single system can bevery costly if the system turns out to be inferior to another system." This typeof standardization may also affect innovation incentives in the market.

Once the market tips toward a single standard, it may remain on that standardand its successors for a long time. Markets may exhibit "excess inertia" andremain locked into a standard, even though an objectively "better" standard isavailable (Katz & Shapiro, 1985; Farrell & Saloner, 1986a). Present users facesubstantial switching costs; even though all users would be better off with thenew standard, those benefits do not accrue to the present users who must payfor switching. New purchasers also may opt for the established standardbecause of the immediate benefit that the established network offers; they donot take account of the benefit that purchasing the new technology wouldconfer on later purchasers. Even if they anticipate the new technology would bewidely adopted, the benefits of that adoption to the purchaser may be so far inthe future that they are substantially discounted (Farrell and Saloner,1986b, at947 n.14).

Theoretical models, however, demonstrate no inevitable tendency of marketsto lock-in on inferior products. Changes in the assumptions underlying themodels (for example, concerning communication and information in the market)may eliminate the outcome of excess inertia (Farrell & Saloner 1985, 1986a;Liebowitz & Margolis 1990). Moreover, markets may actually exhibit "insufficientfriction" (Katz & Shapiro, 1986b, 1994) or "excess momentum" (Farrell & Saloner,1986b), tipping suddenly and inefficiently to new technologies. Insufficientfriction may be inefficient because consumers do not take account of thenetwork benefits their purchase of the established product would confer onexisting users. Given this external benefit, it may be socially preferable to staywith the established technology. Nevertheless, consumers, fearing that they willbe stranded with an obsolete, unsupported technology (the "penguin effect",Farrell & Saloner 1987), may jump to the new technology. Katz and Shapiro(1986b, 1992) suggest that sponsorship of proprietary technologies may lead toinefficient adoption of one technology over another through excess momentum.For example, if the incumbent technology is supplied competitively under ashared standard, a new, proprietary technology might be offered at"penetration" prices in order to attract an installed base. The incumbentcompetitive suppliers would be unable to price below their marginal cost,because they can have no expectation of recoupment.

8. Criticism of the Tipping Scenario

Liebowitz and Margolis (1995a) dispute the suggestion that increasing returnsto scale in high-technology markets lead to market failure. They point out thatthe frequently-observed relationship between increasing participation in amarket with indirect network effects and falling prices is ambiguous. Such arelationship may result from scale economies, but it may also reflecttechnological progress. In the latter case, prices drop because advances intechnology reduce industry costs, not because of a network effect.

Liebowitz and Margolis (1994) also criticize the suggestion that markets failbecause the "wrong" network is chosen, so that total net benefits are lower thatthey would have been under the losing technology. This kind of asserted failureis a function of models that assume inexhaustible scale economies, for only thendoes a single network survive. Liebowitz and Margolis argue that the marginalgains of network size are often exhausted at sizes above a critical mass that issmall relative to the total market. If the benefits of size are exhausted, multiplenetworks can exist. In that event, not only are monopoly problems lessened, butthe theoretical question shifts to whether the best set of networks emerge. Andthe inframarginal externality that may affect the discrete choice of a network "isnot different from other coordination problems that exist in many other marketchoices" (Liebowitz & Margolis 1994, p. 141).

Liebowitz and Margolis are especially critical of claims that networkexternalities lead consumers to make discrete choices among networks, choicesthat do not maximize social welfare. Such externalities cannot be addressed bytaxes and subsidies, because those policies can only affect the scale of anetwork. Rather, the assumed market failures occur because network externalitiessupposedly prevent value-increasing transitions from one technology to asuperior one. At the extreme, the literature seems to suggest that economicactors may easily become forever stuck in technologies that are widelyrecognized as inferior to available alternatives. Liebowitz and Margolis (1994, p.145) colorfully call this the "Chicken Little view of market transitions." Theycontend that economics has generally not done well in explaining transition,which affects all components of the economy, not just networks. Nevertheless,value-increasing transitions do occur, even if the process is not well understood.Evans and Schmalensee (1996) note that, for example, the computer softwaremarket "exemplifies Schumpeter's (1942) view of modern competition--one inwhich firms and industries are constantly created and destroyed through theprocess of innovation."

Whatever the theoretical possibility of market failure brought about bynetwork externalities, critics complain that empirical support has not beenadduced. Proponents of network externalities, for example, have often pointedto the conventional QWERTY keyboard as an illustration of lock-in. Thekeyboard arrangement was chosen, it is said, to slow down the typist to avoidmechanical jamming; other arrangements permit faster typing. Even thoughtechnological improvements have eliminated the mechanical problems, users arelocked-in to the inferior QWERTY arrangement--consumers wish to avoid thecosts of learning a different arrangement, and producers will not supplyalternative products because not enough consumers would purchase them.Liebowitz and Margolis (1990) argue forcefully, however, that the story isfactually incorrect, for the QWERTY keyboard is not demonstrably inferior to theleading alternative. Similarly, Liebowitz & Margolis (1994) find evidence that theBeta videotaping format is no better than VHS. In all, Liebowitz and Margolisbelieve that real indirect network externalities are of limited theoreticalimportance and have not been established empirically. For a similar discussionof the complexity of the issue of objective "superiority" of one technology toanother, see Van Vleck (1995).

D. Compatibility and Standardization Among Network Goods

9. Compatibility and Standardization Among Network Goods

Many of the private and social consequences of network externalities dependupon whether products competing in a network market are compatible in arelevant sense. The term compatibility is used in the literature to refer to differentrelationships depending upon the context. For example, physical networks aresaid to be compatible if they allow direct interconnection; virtual networks aresaid to be compatible if various components of the system are "interoperable,"i.e., they can work together; and various products, such as computer software,may be said to be compatible if consumers can use them without significantretraining (Lemley & O'Brien, 1997). For useful surveys of the issuessurrounding compatibility and standardization in markets with networkexternalities, see Cohen (1996) and Katz and Shapiro (1994).

Whether systems are made compatible depends on a host of factors that mayinfluence decisions of firms on questions of design and contracting with otherproducers. Compatibility may arise as a result of a single firm's product becomingthe de facto standard in the market; or it may arise through collectivestandard-setting mechanisms. In addition, converters or adapters may makeproducts compatible to varying degrees (Farrell & Saloner, 1992). In someinstances, it may be to a firm's advantage to try to prevent compatibility withexisting systems and compete with them to become the de facto standard for atleast a part of the market. In other instances, firms may choose to make theirproducts compatible with other products by licensing or by participation incoalitions or standard-setting organizations. (Katz & Shapiro, 1994).

Compatibility, by expanding the size of networks, offers both private benefitsand private costs to producers and consumers of network goods. Participantsin compatible physical networks receive the direct external benefits ofcommunicating with a larger number of consumers, and save the costs of owningtwo sets of hardware. Participants in compatible virtual networks receive theindirect benefits of a larger network, including a greater variety of componentsthat may be mixed and matched to achieve an optimal system (Matutes andRegibeau, 1988), and a reduced risk of being stranded with obsolete technology.Producers receive the benefits associated with larger scale. Compatibility mayimpose costs, however, depending upon how it is achieved. If it is achieved bystandardization, then there may be a reduction in the variety of systems andproducts available to first-time consumers (Gilbert, 1992). If it is achieved byadapters, the adapters themselves impose costs. (Katz & Shapiro, 1994).

Whether firms have an incentive to create compatibility depends upon howthe resulting changes in the terms of competition affect them. Compatibilityreduces the risk that the market will tip to a rival's sponsored standard, and somay reduce the intensity of competition, at least in early stages whenincompatible systems would be competing to become the market's de factostandard (Katz & Shapiro, 1986b). This tendency suggests that some firms (orcoalitions of firms) may have an incentive to agree to adopt a compatiblestandard (Besen & Farrell 1994; Katz & Shapiro, 1994). But if systems arecompatible, then the market may accommodate more firms, and so compatibilitymay actually increase competition over the long term (Katz & Shapiro, 1994).Firms that standardize reduce their chances of becoming the dominant firm.

When networks are incompatible, then competition is between physicalnetworks or between systems of goods that comprise virtual networks. Whenvirtual networks are compatible, however, competition is among the componentsof the system (Matutes and Regibeau, 1988; Economides 1988, 1996; Katz &Shapiro, 1994). In such situations, the firm's preference for compatibility dependsupon the tradeoff between the increased demand that compatibility creates andthe increased competition that it entails. Firms that believe they offer a betteroverall system (like Apple Computer in its earlier years, perhaps) may opt forincompatibility; firms that believe they offer a better individual component mayopt for compatibility. In general, the "winner take most" nature of competitionbetween incompatible systems may lead firms with very promising (or highlyregarded) technology to oppose compatibility, even when compatibility issocially preferable (Katz & Shapiro, 1994). The social optimum is not achievedbecause firms individually do not take account of the effects of compatibility onothers.

E. Policy Implications

10. Policy Implications: General Remark

The many inefficiencies identified in the network externalities literature have ledsome to propose changes in government policies to accommodate the theory.But most economists have counselled caution in using the network externalitiesliterature to justify greater government intervention. Katz and Shapiro (1994), forexample note that private market responses may correct any inefficiency.Furthermore, they point out that interest group pressures make governmentresponses less likely to favor efficiency than powerful incumbent producers.And there is little reason to think the government has the ability to identify thecorrect market outcome better than market mechanisms (Arrow, 1995; Vita &Wellford, 1994; Page & Lopatka, 1995a, 1995b). Liebowitz and Margolis (1994)are even more insistent that the network externalities literature is far too limitedin its theoretical implications and its empirical support to justify a moreinterventionist government policy.

Nevertheless, legal literature and to a lesser extent the case law have begunto take account of network externalities. A search of the WESTLAW "Journalsand Law Reviews" database reveals over one hundred fifty references to"network externalities" in diverse areas of law. And the concept has begun to beaccepted by some policymakers and courts. The following sections will addresssome of these issues.

11. Antitrust: Monopolization

Because it predicts that a single firm may dominate a market, networkexternalities theory has been recruited to support claims of monopolization. Itimplies that a firm may have an incentive to make its network incompatible, toachieve higher sales volumes than its competitors during early stages ofproduction, and to convince potential users that its standard eventually willprevail. The practices that a firm uses to influence the direction in which themarket tips are likely to be attacked as exclusionary. For example, in EastmanKodak Co. v. Image Technical Services, Inc. (1992), the Supreme Court held thatan equipment manufacturer (without monopoly power in the equipment market)could have monopolized by requiring consumers to purchase its repair servicesas a condition of obtaining its replacement parts. The Court did not mentionnetwork externalities explicitly, but did treat the equipment, services, and partsas a sort of system. Recall that Katz and Shapiro (1994) specifically refer to"durable equipment and repair services" as an example of the hardware/softwareparadigm, or an indirect network. The Court's reasoning closely resembles anetwork externalities analysis. It stated that purchasers were locked-in to Kodakequipment and would find it costly to predict the prices of aftermarket servicesand products at the time of equipment purchase. High switching costs andimperfect information are important features of network externalities theory.

The United States, in its amicus brief in Kodak, appeared to reject networkexternalities theory by arguing that Kodak could not extract monopoly profitsin aftermarkets because it lacked monopoly power in the equipment market. Butthe Antitrust Division under the Clinton administration explicitly invokednetwork externalities theory in suing Microsoft for monopolizing the market inpersonal computer operating systems, although it limited the scope of itscomplaint to restraints in Microsoft's distribution contracts (United States v.Microsoft, 1995). In the litigation challenging the consent decree in that case, allsides (and the District Court) agreed that network externalities in the hardwareand software markets had important antitrust implications and might justifystricter application of monopolization standards. A group of anonymous amicicuriae filed a brief that was co-authored by Brian Arthur and Garth Saloner, bothprominent theorists of network externalities. For a full analysis of the brief andthe district court's opinion, see Lopatka & Page (1995a).

Network externalities theory has limitations as a policy guide inmonopolization cases. (Lopatka & Page, 1995a, 1995b; Evans & Schmalensee,1996; Gifford, 1996). It does not, for example, support breakup of a firm thatachieves dominance. The theory predicts that networks will often grow large forefficiency reasons. Tipping does not necessarily imply that a producer is foreverlocked in, because new technology (and creative new producers) can benefitfrom the same phenomenon to leapfrog the old dominant firm. The verypossibility of tipping is an important incentive to innovation and novelmarketing strategies. And history contains enough examples of technologicalchange sweeping away previously dominant firms to caution againstgovernment action to break up a market leader.

Lock-in may not even signal market failure. A firm may dominate because itin fact offers the best product. An antitrust court could not confidently declarethat the wrong technology had triumphed (Vita & Wellford, 1994). While excessinertia is possible, theory does not tell us when it is present. Thus there is nojustification for encouraging displacement of a dominant firm by weakening itslocked-in position. Nor is there justification for detailed supervision of thedominant firm's practices. If the market is a natural monopoly, it is not well suitedto antitrust regulation, regardless of network externalities.

For similar reasons, network externalities theory does not offer muchassistance in identifying "exclusionary" conduct that creates monopoly power.Some models suggest that markets can be tipped by trivial events or an earlyadvantage, so that the development of the market is path dependent (Arthur,1989; David, 1985). Microsoft's MS-DOS operating system may have achieveddominance because IBM selected it long ago for the IBM PC (Besen & Farrell,1994). If historic accident determines market outcomes, however, none ofMicrosoft's subsequent competitive acts can be blamed for its dominantposition. Some practices may be theoretically inefficient, but courts lack theknowledge to identify when they are so. Firms may, for example, use advertisingto manipulate consumers' expectations about which standard will prevail (Besen& Farrell, 1994; Katz & Shapiro, 1994). Or they may use productpreannouncements to discourage existing customers from switching to anothersupplier and to encourage prospective purchasers to wait (Farrell & Saloner,1986b). But there is no effective way to distinguish these practices from efficientdissemination of information (Ordover & Willig, 1981).

Network externalities theory may actually provide efficiency explanations forapparently exclusionary practices. For example, vertical integration or exclusivecontracts may allow a producer to establish a credible commitment to provide asupply of complementary goods. Similarly, a lease-only policy (sometimessuspect in antitrust law) may be an effort to assure consumers that they will notbe locked in to a dying network.

Predatory pricing issues may also be influenced by network externalities.Katz & Shapiro (1994, p. 104), describe "penetration pricing": "by sellinghardware below cost early on, the network sponsor is stimulating the demandfor software, which may lead to a lower price of software if software is producedaccording to economies of scale or if the elasticity of demand for software ishigher for marginal consumers than for the average hardware consumer" (Seealso Besen & Farrel, 1994). This pricing strategy may resemble predatory pricing;but its goal is to overcome network externalities in building an installed base.Below-cost pricing or even giveaways of some products, like computer software,may be a rational means of establishing an installed base of complementaryproduct sold by the same firm. Farrell (1989) suggests that this sort ofcompetitive below-cost pricing by sponsors of proprietary technologies willtypically lead to the better technology being adopted. Thus, Lemley (1996)concludes that such a price war raises concerns only if it is asymmetric, that is,if one of the combatants has greater staying power.

Although network externality theory is susceptible to misuse in the analysisof monopolization, it may sometimes provide a helpful context for examiningallegedly exclusionary conduct. For example, Lemley (1996) suggests thatconcealment of a proprietary claim to a market standard during a period in whichthat standard is being promoted for acceptance in the market or bystandard-setting organizations may be monopolistic.

12. Antitrust: Horizontal and Vertical Agreements

Antitrust's traditional hostility to horizontal agreements may cast suspicion onsome agreements in network industries. But antitrust has also recognized thatsome industries require cooperation in order to exist. (See, e.g., NationalCollegiate Athletic Ass'n v. Board of Regents, 1984). Network industries oftenfall in this category (Carlton & Klamer, 1983; Evans & Schmalensee, 1996).Perfect competition may be inefficient (in physical networks) or entirelyimpractical (in virtual networks). Network externalities can often be internalizedonly by contract or joint ownership. Bank credit cards require cooperationamong banks in order to compete with cards issued by a single firm (Carlton &Frankel, 1995). Telecommunications networks require agreements oninterconnection and sharing of joint costs and revenues. Producers of bothhardware and software must settle on standards to assure compatibility (Brown,1993). Lemley (1996) mentions the Internet Engineering Task Force as an exampleof a necessary standard-setting organization. While these points suggestprocompetitive explanations for some types of agreements, they do not excludethe possibility of such an organization being used as a cartel or an exclusionarydevice. Some network joint ventures may thus require continuing antitrustcontrols. Real estate multilisting services offer network benefits, but do notjustify price fixing by participating realtors. And network externalities do notimply that standard-setting joint ventures should be permitted to excludecompetitors (Anton & Yao, 1995).

Mergers and joint ventures have become common in network industries.Network externality theory offers a number of efficiency justifications for thesearrangements. Physical networks may offer greater value to subscribers bymerging, and may benefit from scale economies and greater information.Research and development joint ventures may permit firms to pool informationand resources to create more advanced technology. These considerations donot, however, imply that antitrust scrutiny is inappropriate. A merger creatinga network that is larger than is justified by scale economies may create anunnecessary danger of monopoly. In Money Station, Inc. v. Board of Governorsof Federal Reserve System, the Board argued to the court that an acquisition ofa small ATM network by a bank controlling the dominant ATM network wasless likely to lead to anticompetitive effects because (p. 1133):

Network externalities, such as the economies of ubiquity, tend topromote the consolidation of regional ATM networks. As a result, invarious geographic areas, like the Mideast region, dominant ATMnetworks have been emerging throughout the EFT industry. One recentstudy indicates that the ten largest regional networks now account for80 percent of all regional ATM transactions in the United States. In thislight, the Board believes that, as a result of economic and marketstructure conditions, regions are likely to have one dominant ATMnetwork.

The court properly questioned this reasoning as a way of avoiding competitiveconcerns about the merger. It is not clear that network externalities requiredominance of a single firm.

13. Intellectual Protection for Proprietary Standards

The theory of network externalities suggests that a single product may emergeas the de facto standard in the market. Should the presence of networkexternalites, and the consequent danger of lock-in, affect the intellectualproperty protection given to a proprietary de facto standard? Menell (1987,1989), relying in part on an analogy to the QWERTY story, has argued thatnetwork externalities justify limiting copyright protection to computer softwarethat has become the industry standard. In Lotus Development Corp. v. BorlandInternational (1995), the court adopted this reasoning, holding that Lotus 1-2-3'suser interface was a "method of operation," like the buttons on a VCR, andtherefore not protectable expression under copyright law. One of the reasons thecourt offered was the need for compatibility. The court found it "absurd" tosuggest that "if a user uses several different programs, he or she must learn howto perform the same operation in a different way for each program used." Aconcurring judge added that "if Lotus is granted a monopoly on this pattern,users who have learned the command structure of Lotus 1-2-3 or devised theirown macros are locked into Lotus. . . ." Consequently, a competitor (Borland)should be allowed to copy Lotus's menu command structure.

This decision adopts a network externality theory raised by Borland andamici curiae in their briefs on appeal. It has been questioned by Dam (1995), whopoints out that "compatibility" in this case is not the interoperability that allowsuse of competitive software or the inteconnection that allows communicationacross a physical network. Rather, compatibility in this case means only that auser may costlessly adopt a competing product. The argument is that the menustructure has become the de facto industry standard, and so free copying shouldbe allowed to assure adequate competition. But it is questionable whethernetwork externalities are at issue here. The users of Lotus 1-2-3 do not constitutea physical network, so there are no direct external benefits from expansion of theinstalled base. Furthermore, the case does not involve complementary products,so there are no apparent indirect network externalities from greater availabilityof compatible goods. There are at best so-called convenience externalities. Thereare switching costs between spreadsheets, but not evidently more than betweenproducts generally.

One difficulty with the use of network externalities to limit copyrightprotection is that it is difficult to limit the principle to computer software. It hasbeen suggested that many popular copyrighted works, such as Gone With theWind, create a network of users that may be exploited in spinoffs and sequels.Thus, the case of computer software does not appear to be unique amongcopyrighted products (Lunney, 1996). More generally, the application of thenetwork externalities concept to negate copyright protection for popularsoftware is similar to the antitrust argument that the successful firm hasmonopolized, and is questionable for the same reasons. Weakening copyrightprotection allows greater competition by clones, but reduces the payoff forinnovators, by threatening loss of protection for successful firms.

14. Contract Terms and Other Norms

Some scholars have argued that social norms have network aspects.Conventional rules like those governing right of way for drivers at anintersection have greater value the more people adopt them. This extension ofthe concept of network externalities has been most fully developed by Klausnerand Kahan (Klausner, 1995; Kahan & Klausner, 1996), who have argued that theadoption of corporate contract terms can create indirect network externalities.Common use and judicial interpretation of contract terms benefit the "network"of firms adopting those terms by, for example, clarifying the meaning of the setof legal rules governing the firm. Larger network size generates positive feedbackbecause it increases the stock of judicial precedent and the commonunderstanding of the relevant rules. Network externalities thus modify theconception of the firm as a nexus of contracts. They imply that contract termsthat maximize the value of the individual firm may not maximize social wealth.State corporation laws, by providing default rules for contractual provisions, areanalogous to industry standards in physical networks like telecommunications,because they can facilitate the creation of networks. Their goal should be topromote the creation of an optimal mix of uniformity and diversity by providing"open-ended" default rules menus of alternative provisions. Networkexternalities may also account for the dominance of Delaware corporation law.Some scholars have suggested that states compete in a race to the top forcorporate charters by offering statutes that maximize firm value. But Delaware'sdominance (despite the prevalence of similar laws) may reflect the positivefeedback effect of its large network of incorporated firms. This result implies thatDelaware law has become popular not because it offers optimal terms, butbecause it has become locked in.

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© Copyright 1997 William H. Page and John E. Lopatka

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