Networks


 * __Networks: a comprehensive Overview__**

A **network** consists of links that connect different points (//nodes//) in geographic or economic space. Relative to business and economics, networks play a profound role in the organization of many industries including: telecommunications, airlines and the internet. A **network effect** or **network externalities** is a characteristic that causes a good or service to have a value to a potential customer which depends on the number of other customers who own the good or are users of the service. In other words, the number of prior adopters is an element in the value available to the next adopter.² We will highlight in the following paragraphs the manifestation of first mover advantages as a result of networks, the lock-in phenomenon that inherently traps consumers into inferior products and services and potential strategies to overcome the barriers to entry created from networks and network effects (externalities).
 * //__Definition and Application:__//**

The simplest type of network is a //one-way// network in which services flow in only one direction. An example of a one-way network is residential water service. Water will flow one-way from the local service provider to respective homes in the community. One-way networks can lead to first-mover advantages because of economies of scale or scope. Because the local water company often enjoys economies of scale in creating a network to deliver service to its customers, new entrants typically find it difficult to build a network that supplants the network services of a well-established incumbent. The distinguishing feature of a one way network is that its value to each user //does **not**// directly depend on how many other people use the network.¹ Put another way, one-way networks do not suffer from the direct network effect. One-way networks can be the beneficiary of indirect network effects.
 * //One-Way Networks://**

Two-way networks (such as telephone systems or email) are directly impacted by network externalities. In two-way networks the value to each user depends directly on how many other people use the network. This is significant because this many permit an existing two-way network provider to enjoy significant first-mover advantages even in the absence of any significant economies of scale.¹ A graphical depiction of a two-way network is a star network shown in the graph below. This graph is a representation of an airline industry (excluding Southwest) and how it offers its transportation services to various cities (labeled C1 through C7). In essence a consumer can fly to any one of the seven locations, but instead flying direct to the desired location, they will be routed to a hub (labeled ‘H’). Two-way networks that link users exhibit positive externalities called direct network externalities, whereby the per unit value of the services provided by a network increases as the size of the network grows. For example, if there are 5 users in a telephone network it is inferior in value to a telephone network with 10 users. To precisely quantify the value of direct network externalities we can see that a two-way network linking //n// users, provides //n*(n//-1) potential connection services. If one new user joins the network, all the existing users directly benefit because the new user adds 2*(n) potential connections services to the network.
 * //Two-Way Networks://**
 * //Direct Network Externalities://**

//**Indirect Network Externalities:**// In addition to direct externalities in two-way networks, //indirect network externalities// also can exist, and they can be present in both two-way and one-way networks. Another term for indirect externalities is //network complementarities//. By definition, this is the indirect value enjoyed by the user of a network because of complementarities between the size of a network and the availability of complementary products and services. The most pervasive example of network complementarities was the explosion in the use of electricity which led to the development of millions of different types of electrical appliances.

//**Negative Externalities:**// Both the direct and indirect externalities described above were positive. However, there are also negative externalities that surface as a result of network size. The best example is //bottlenecks// or the point where the existing infrastructure cannot handle additional users.¹ Bottlenecks make it harder for users to make network connections and the value per user of the services begins to decline.

//**Networks and Consumer Behavior -- Real-world Application:**// Because of network externalities, it is often difficult for new networks to replace or compete with existing networks. This is true because the established network is likely to have many users and complementary services which make the total value of the existing network greater for each user than a new network with relatively few users or network complementarities. What if the new network has superior technology and the users are better off? Consider the network game below:



The users in this game must choose a network provider (H1 or H2). Both users are initially using network provider H1, because of first-mover advantage. Notice that when the new network becomes available (H2), if both users utilized it they would be better off. However, neither user has a unilateral incentive to change network providers because they would be worse off if the other user(s) did not follow. In essence, the network externalities create a consumer //**lock-in**// where consumers are stuck in a situation where they are using an inferior network. This phenomenon can be demonstrated recently by the mass movement of society to utilize a cellular phone. A large cell phone service provider understood the network effect and implemented a strategy to create the largest network or coverage area to serve as a basis for competitive advantage. However, with cellular phones, one network user can easily call a different network user. To exploit direct network externalities they began offering free in-service calling to all customers in their network. Essentially they are exerting direct network externalities to add value to both their current customers and more importantly, potential customers. (Charging higher prices for 'off-net' calls is a strategy pursued by many network operators in many countries as well.³) There's no secret to their strategy, they often tout their 'network' in their remarkably simple advertising whereby their network always follows them and a myriad of contacts and resources are at their fingertips. Once they accomplished this exclusive value they begin creating complementaries (indirect externalities) such as new cell phone discounts or even free cell phone upgrades after a certain period of time brought on in exchange for long term contracts. Additional indirect externalities are created from multimedia/data services and most recently the integration of music players and massive storage.⁴

What can a firm do to establish its network? One way is through //**penetration pricing**// or charging an initial price that is very low -- potentially even giving the product away for free or paying customers to try out the new product. This protects the users from the risk that other users will not switch to the new technology and thereby lowering the switching costs.
 * //How Does a Firm Exploit this Phenomenon?//**

Consider the previous game with a new penetration pricing strategy:

In the second game, suppose the new service provider allows the consumer to keep their original network and to try the new network and the new network provider pays users a small amount ($1) to try the new service. Now, during the ‘trial’ period each consumer has the incentive to try the new network since H1 & H2 is a dominant strategy for each user. And even if the other consumer(s) don't switch networks their is no negative externality associated with the trial period. Once a critical mass of users’ trial the new service and realize its superiority the new provider can eliminate the $1 payment and ultimately increase the price charged for access to its network.

__1. Which is an example of a one-way network?__ a. Internet Network b. Cable Service Network c. Telephone Network d. Airline Network
 * Questions:**

Answer: b Cable service is a one-way network because the services flow in only one direction. Digital cable services are different and some regions have pay-per view services. Basic cable is a one-way network.

__2. Direct network externalities are:__ a. The direct value enjoyed by the user of a network because others also use the network b. Effect both one-way and two-way networks c. Only are positive (there are no negative externalities)

Answer: a Direct network externalities effect only two-way networks and there are both positive and negative externalities that exist.

__3. A two-way network linking 25 users provides how many potential connection services?__ a. 150 b. 300 c. 450 d. 600

Answer: d A two-way network linking 25 users provides 25*(25-1) potential connection services. Formula: n*(n-1).

__4. Which of the following is an example of a negative externality?__ a. Network complementarities b. First-Mover advantages c. Bottlenecks d. Consumer Lock-in

Answer: c First-mover advantages and consumer lock-in are functions of direct and indirect positive externalities. A bottleneck is a negative externality that can arise in networks.

__5. Which is a strategy a new firm can employ to incent consumers to 'trial' their new service?__ a. Premium pricing b. Predatory pricing c. Limit pricing d. Penetration Pricing

Answer: d Penetration pricing entails charging an initial price that is very low in an attempt to persuade customers to try out a new product.

¹Baye, Michael R., "Managerial Economics and Business Strategy", Fifth Edition, Mc-Graw Hill, 2007 ² http://en.wikipedia.org/wiki/Network_effect ³. Birke, Daniel; Swann, Peter; "Network Effects and the Choice of a Mobile Phone Operator" Journal of Evolutionary Economics. 16:65-84 (2006). ⁴. Katz, Michael; Shapiro, Carl; "Systems Competition and Network Effects" Journal of Economic Perspectives" Vol 8, Number 2; Spring, 1994.