In a market where firms compete to become the dominant provider, whether as a monopolist or an oligopolist, firms use strategies to strengthen and maintain their market power. In such a market, government must assess the effects of these strategies on consumers. Unlike other firms with market power, those producing network goods face the continuing threat that a new network good might lead them into a vicious cycle. Therefore, competition can exist even when a network good is dominated by a single firm. This brings about the important question of whether or not government should regulate these firms.

Microsoft’s market dominance with its Windows operating system, office-suite products (Office), and email and Internet programs (Outlook and Explorer) led the U.S. Department of Justice, along with governments in the European Union, to investigate whether this dominance was achieved fairly. Specifically, some question Microsoft’s bundling tactics, which make it convenient (perhaps too convenient) to adopt its related products once one product is purchased.

The government generally aims to ensure that competition for network goods leads to low prices for consumers, ample choices, and improvements in quality. However, governments also must ensure that regulations do not impede productivity or create burdensome costs to firms. Just because a firm is a monopoly does not mean it doesn’t face the threat of competition, which can keep firms from exploiting their market power.

One way to promote a competitive environment for network goods is not to break up monopolies, but rather to ensure that firms are prevented from securing exclusive access to a set of consumers. One such regulatory policy is to require interconnection.

Many types of network goods include industry standards or essential facilities. An industry standard is a common format that is used, for example, in televisions, in digital recorders, and in software programs. Essential facilities are inputs that are needed to produce a product or to allow a person to consume a product. Interconnection, the physical linking of a network to another network’s essential facilities, helps to promote competition in situations in which firms are able to use their market power to block competitors from entering the industry. When interconnection is required, firms must allow competing providers access to their networks. As discussed in the chapter opener, a Verizon customer, for example, must be able to make a call to an AT&T customer in order for multiple networks to operate efficiently in the same market. For such calls to be possible, they must travel across networks owned by different firms.

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Consider the incredible arrangement of networks required to make a telephone call to a friend in another country. To complete this call, parties must work together, starting with a wireless provider or local telephone provider (called a local exchange carrier), connecting to the distance call provider, then the network provider interconnecting to the foreign network operator, and finally connecting to the friend’s local exchange carrier. Even more amazing is how the cost of this service has fallen dramatically over the years. How is this possible? We looked at the role of network effects, network competition, and interconnection to explain how competing networks are able to provide efficient and seamless service that in the past could only be possible via large natural monopolies. What is more important is the degree to which global markets are dependent on network technologies that did not exist 15 years ago—technologies that we often take for granted today.

An important role of regulation in network goods is to ensure that providers of essential facilities allow access to competing firms. The most common example of an essential facility is the phone line in your house. Prior to 1984, AT&T owned about 80% of all of these phone lines, and could effectively prevent any competitor from offering phone service because rival firms would not be able to complete a call without access to your (i.e., AT&T’s) phone line. In 1984 the U.S. government forced AT&T to break up into smaller firms, and eventually forced these firms to open their networks to competition, paving the way for both land-based and wireless providers to enter the market. The effect on prices was substantial. If you watch an old TV show from the 1970s or early 1980s, you may catch some interesting scenes in which characters make a big deal about calling long distance. Today, we don’t think twice about calling long distance, or even making international calls. In fact, long-distance calling has lost its identity as a market, leading to the demise of many long-distance companies.

A common issue with network goods is that firms tend to compete vigorously (leading to standards wars) to become the industry standard, thereby “owning” the network. A consequence of this competition is that firms spend large sums of money on marketing strategies to dominate the market (to become a monopoly), rather than to achieve productivity gains and cost reductions typical of more competitive markets. Network compatibility allows competing standards to coexist in a market by ensuring that media can be used on competing formats. For example, a spreadsheet can be shared by a person using a Windows computer and someone using a Mac computer. And the spreadsheet itself can be edited using either Microsoft Excel or Google Docs.

A common theme throughout the discussions of market structure in earlier chapters is that competitive markets generate more consumer surplus than monopoly markets. Further, firms with market power generate deadweight loss. In network industries where monopolies can be created if network effects are strong, interconnection can bring about gains to society by facilitating competition and reducing deadweight loss.

In the long run, interconnection creates a more competitive environment that forces firms to be more efficient, leading to reduced costs. Yet, a more competitive market might limit the network effects and economies of scale that exist with fewer firms. Therefore, implementing regulation to promote competition involves a tradeoff between benefits and costs. In fact, the potential costs of regulation can even exceed the benefits.

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Throughout this section, it was argued that regulation can promote competition by preventing firms from exploiting their access to essential facilities. However, the benefits of network effects most likely contributed to a firm’s dominance in the market. For example, although we enjoy having our choice of wireless carriers, which is a benefit from regulation, such choices do not come without cost.

Competition for exclusive contracts with phone makers has made it difficult to use certain providers with certain phones. A similar situation arises in sports broadcasting, in which television networks sign contracts with sports organizations to be the sole broadcaster of games to viewers (such as ESPN’s exclusive right to broadcast Monday Night Football). Although these cases create minor burdens, other forms of regulation intended to protect consumers have led to major disasters.

The California electricity crisis of 2000–2001 is one such example of poor regulation of a network good. Although the initial objective of placing a price cap (a price ceiling) on electricity prices was to keep prices from rising too rapidly for consumers, it quickly led to strategic responses by producers. Because producers could not raise prices in California to compensate for rising input prices, many firms instead chose to reduce the quantity of electricity provided, creating a huge shortage of electricity. Ultimately, the price ceiling led to massive blackouts and much inconvenience to individuals and businesses for several months.

When determining whether network goods should be regulated or not, the benefits and costs of each policy must be evaluated to determine whether it would be best to implement the policy or to just leave the market alone. In many situations, such as with the California electricity price cap, life might have been brighter (pun intended) without regulation.