Network Externalities
1. Introduction
With the rapid development of new communications technology and network technology, some industries such as information industry show significant network externality characteristics. Network externality has been defined as "a change in the benefit, or surplus, that an agent derives from a good when the number of other agent consuming the same kind of good changes" (Liebowitz & Margolis, 1996). In other words, the product will be more valuable if more people use it. For example, the telephone becomes increasingly valuable since people have greater use of it. Therefore, the network externality has essentially a positive feedback effect. This paper aims to explain the concept of network externalities and apply this theory into real-life examples.
In the first part, it provides a literature review for network externalities. The second part analyses of direct network effect, and the third part gives indirect network effect. An example is given in the fourth part and finally the paper draws a main conclusion.
2. Network Externalities – Literature Review
Katz and Shapiro (1994) explain the theory of network externalities and how consumers behave when they face choices. The literature examines how expectations, coordination, and compatibility affect three basic clusters of decisions: technology adoption decisions, product selection decisions and compatibility decisions. Expectations mean that rational buyers form the components that they will be buying in the future in terms of availability, price and quality (Katz & Shapiro, 1994). Coordination is defined as ‘system markets pose challenges for coordination among firms and consumers’ (Katz & Shapiro, 1994). Compatibility is defined as ‘a component designed to work in one system also work in another system’ (Katz & Shapiro, 1994). The article indicates that communication network has direct network effects, while the hardware/software paradigm involves indirect network effects. By using
With the rapid development of new communications technology and network technology, some industries such as information industry show significant network externality characteristics. Network externality has been defined as "a change in the benefit, or surplus, that an agent derives from a good when the number of other agent consuming the same kind of good changes" (Liebowitz & Margolis, 1996). In other words, the product will be more valuable if more people use it. For example, the telephone becomes increasingly valuable since people have greater use of it. Therefore, the network externality has essentially a positive feedback effect. This paper aims to explain the concept of network externalities and apply this theory into real-life examples.
In the first part, it provides a literature review for network externalities. The second part analyses of direct network effect, and the third part gives indirect network effect. An example is given in the fourth part and finally the paper draws a main conclusion.
2. Network Externalities – Literature Review
Katz and Shapiro (1994) explain the theory of network externalities and how consumers behave when they face choices. The literature examines how expectations, coordination, and compatibility affect three basic clusters of decisions: technology adoption decisions, product selection decisions and compatibility decisions. Expectations mean that rational buyers form the components that they will be buying in the future in terms of availability, price and quality (Katz & Shapiro, 1994). Coordination is defined as ‘system markets pose challenges for coordination among firms and consumers’ (Katz & Shapiro, 1994). Compatibility is defined as ‘a component designed to work in one system also work in another system’ (Katz & Shapiro, 1994). The article indicates that communication network has direct network effects, while the hardware/software paradigm involves indirect network effects. By using
References: Katz, M.L. & Shapiro, C. (1994). Systems competition and network effects. Journal of Economic Perspectives 8, 93–115. Liebowitz, S.J. & Margolis, S.E. (1996). Network Externalities (Effects). Retrieved On 11 October 2010, from: http://www.utdallas.edu/~liebowit/palgrave/network.html