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 doesn’t matter whether it’s cheaper to make more rackets than fewer rackets. This is a network externality. Manufacturing many copies of the same digital camera is cheaper, per camera, than making only a few. It doesn’t matter whether people benefit from all using the same camera. This is an economy of scale.

Games Solitaire doesn’t have any network externality. You don’t 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://gabe.web.psi.ch/research/imp/ They 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 plant’s emissions, both health costs and decreases in agricultural yields.

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 it’s too smelly to enjoy the location.

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 neighbor’s house goes up slightly. You won’t 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 isn’t reflected directly in the price of your train ticket (although the government may subsidize rail travel for that reason).

Bee

Beekeeping 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)

Lighthouses “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 Samuelson’s 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 he’s never going to satisfy the more extreme critics. (Anyway, he’s 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 doesn’t work out well: pretty soon the companies must either interconnect or merge.

Standards 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 isn’t 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 Microsoft’s market success.

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 Sony’s Blu-Ray vs. Toshiba’s 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 Krugman’s status as a liberal columnist than with technology.

QWERTY-Dvorak 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 code).

Being first “Pioneers are the guys with the arrows in their backs” It isn’t always important to be first. It’s 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. Amazon.com 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.

Microsoft 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 Microsoft’s monopoly position lets it raise prices for a bigger profit than, say, Intel or Dell per sale). In today’s politics, people will defend unregulated monopoly but they will not defend regulated monopoly.

Zune 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).

Information 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. Isn’t 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?

Classification Once upon a time many major libraries had their own classification systems. Eventually they all joined either Dewey or LC. Mostly: “economy of scale” – it’s 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?

Language 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, it’s not likely to get attention. Before telecommunications, this was less of a problem; if you’re 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 wouldn’t 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 didn’t matter. Then the Channel Tunnel was dug, and it’s now inconvenient that continental-size trains don’t 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 important.

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. I’m fairly pessimistic; I don’t see why independent libraries should be more viable than independent bookstores, or than independent radio stations.

Network Externalities