The External Benefits of a Network Externality

We can now deepen our understanding of network externalities by noting that a network externality involves an external benefit: one person’s adoption of a good or service extends an external benefit to another person who also adopts that good or service. As a result, the marginal benefit of the good or service to any one person depends on the number of other people who also use it.

Although the most common network externalities involve methods of communication—the internet, cell phones, social media, and so on—they are also frequently present in transportation. For example, the value to a traveler of a given airport increases as more travelers use that airport as well, making more airlines and more destinations available from it. A marketplace website like eBay is more valuable to use, either to buy or to sell, the greater the number of other people also using that site. Similarly, many of us value banking with a particular bank because of the number of ATMs it has, and it will have more ATMs the larger its customer base.

The classic case of network externalities in the high-tech industry arises from computer operating systems. Most personal computers around the world run on Windows by Microsoft rather than on Apple’s competing system. In 2013, 18.8 new PCs that run Windows were sold for every Apple Mac sold. Why does Windows dominate personal computers? There are two channels, both involving network externalities. First, a direct effect: it is easier for a Windows user to get help and advice from other Windows users. Second, an indirect effect: Window’s early dominance attracted more software developers, so more programs were developed to run on Windows than on a competing system. (This second effect has largely vanished now, but it was important early on in making PCs dominant.)

Today, social media websites are perhaps the best illustration of a network externality at work, a subject we’ll address in this chapter’s business case.

A good is subject to positive feedback when success breeds greater success and failure breeds further failure.

When a network externality arises from the use of a good or service, it leads to positive feedback, also known as a bandwagon effect: if large numbers of people use it, other people become more likely to use it too. And if fewer people use the good or service, others become less likely to use it as well. This leads to a chicken-versus-egg-problem: if one person’s value of the good depends on whether another person also uses the good, how do you get anyone to buy the good in the first place? Not surprisingly, producers of goods and services with network externalities are aware of this problem. They understand that of two competing products, the one with the largest network—not necessarily the one that’s the better product—will win in the end. The product with the larger network will continue to grow and dominate the market, while its rival will shrink and eventually disappear.

Everyone wants to join the network that everyone else joins.
iStockphoto

An important way to gain an advantage at the early stages of a market with network externalities is to sell the product cheaply, perhaps at a loss, in order to increase the size of the network of users. For example, Skype, the internet calling company, allows free calls from one Skype member to another Skype member via the internet. This builds Skype’s network of users, who will then pay for using Skype to call a non-Skype contact or place a call to a landline phone. And as we explain in the following Economics in Action, the fact that all web browsers—including Internet Explorer, Chrome, and Firefox—are free to download is a legacy of Microsoft’s early strategy of providing Internet Explorer free on its computers in order to buttress its Windows operating system dominance.

Network externalities present special challenges for antitrust regulators because the antitrust laws do not, strictly speaking, forbid monopoly. Rather, they only prohibit monopolization—efforts to create a monopoly. If you just happen to end up ruling an industry, that’s OK, but if you take actions designed to drive out competition, that’s not OK. So we could argue that monopolies in goods with network externalities, because they occur naturally, should not pose legal problems.

Unfortunately, it isn’t that simple. Firms investing in new technologies are clearly trying to establish monopoly positions. Furthermore, in the face of positive feedback, firms have an incentive to engage in aggressive strategies to push their goods in order to increase their network size and tip the market in their favor. So what is the dividing line between legal and illegal actions? In the Microsoft antitrust case, described next, reasonable economists and legal experts disagreed sharply about whether the company had broken the law.

ECONOMICS in Action: The Microsoft Case

The Microsoft Case

In 2011, a consent decree between Microsoft and a federal court prohibiting certain business practices expired, marking the end of an era for the company. Beginning in 1998, the federal Justice Department as well as 20 states and the District of Columbia sued Microsoft, alleging predatory practices against competitors to protect the monopoly position held by its Windows operating system. At the time, Microsoft was by any reasonable definition a monopoly, as just about all personal computers in the late 1990s ran Windows. And the key feature supporting this dominance was a network externality: people used Windows because other people used Windows.

The Microsoft case was a good example of the pros and cons raised by goods with network externalities.
AFP/Getty Images

Despite urging by some economists, the Justice Department did not challenge the Windows monopoly itself, as most experts agreed that monopoly was the natural outcome of an industry with network externalities. What Justice Department lawyers did claim, however, was that Microsoft had used the monopoly position of its Windows operating system to give its other products an unfair advantage over competitors.

For example, by bundling Internet Explorer free as part of Windows, it was alleged that Microsoft had given itself an unfair advantage over rival web browser Netscape, because it prevented Netscape from charging customers for its use. The Justice Department argued that this was harmful because it discouraged innovation: potential software innovators were unwilling to invest large sums out of fear that Microsoft would bundle an equivalent software with Windows free. Microsoft, in contrast, argued that by setting the precedent that companies would be punished for success, the government was the real opponent of innovation.

After many years of legal wrangling, the consent decree was signed in 2002, which barred Microsoft from excluding rivals from its computers and forced the company to make Windows seamlessly interoperable with non-Microsoft software. This eliminated any advantage Microsoft had through free bundling of its own programs into the Windows package.

Although the case against Microsoft consumed many tens of millions of dollars in legal costs and is considered one of the most significant antitrust cases of its generation, its long-term effects are hotly debated. Some say that the case essentially had no effect, as the cutting edge of technology moved into mobile devices like smartphones and tablets, leaving Microsoft and its PC-centered business behind. Others argue that, although the case may not have dampened overall innovation as Microsoft claimed, it changed the culture of Microsoft itself, making it more cautious and therefore unable to explore and capitalize on new technological trends.

Two effects, however, are beyond dispute. Because of Microsoft’s example, products with network externalities are often priced at a loss or even at zero—as in the case of today’s web browsers, Chrome, Firefox, and Internet Explorer, which are all available free. Second, rival high-tech companies now routinely charge one another with predatory behavior that exploits a network externality advantage—as in Microsoft’s recent charges against Google for its advantage in the search engine market.

Quick Review

  • Network externalities arise when the value of a good increases when a large number of other people also use the good. They are prevalent in communications, transportation, and high-technology industries.

  • Goods with network externalities exhibit positive feedback: success breeds further success, and failure breeds further failure. The good with the largest network eventually dominates the market, and rival goods disappear. As a result, in early stages of the market, firms have an incentive to take aggressive actions, such as lowering price below production cost, to enlarge the size of their good’s network.

  • Goods with network externalities pose special problems for antitrust regulators because they tend toward monopoly. It can be difficult to distinguish what is a natural growth of the network and what is an illegal monopolization effort by the producer.

16-4

  1. Question 16.7

    For each of the following goods, explain the nature of the network externality present.

    1. Appliances using a particular voltage, such as 110 volts versus 220 volts

    2. 8½-by-11-inch paper versus 8-by-12½-inch paper

  2. Question 16.8

    Suppose there are two competing companies in an industry that has a network externality. Explain why it is likely that the company able to sustain the largest initial losses will eventually dominate the market.

Solutions appear at back of book.

Are We Still Friends? A Tale of Facebook, MySpace, and Friendster

There was a big shake-out in the world of social media websites in 2011. That year Facebook was in the midst of negotiating a half-billion dollar investment, MySpace was preparing to fire nearly half its staff, and Friendster was transformed from a failed social media website to an online gaming website. The irony of these events is that Friendster and MySpace started before Facebook—Friendster in 2002, MySpace in 2003, and Facebook in 2004. Yet, by 2011 Friendster was in complete collapse and MySpace was in steep decline.

By 2013, MySpace’s registered users fell by a third, to 36 million, compared to 54 million in 2011. As the former president of MTV Networks, Michael J. Wolf, commented, “MySpace was like a big party, and then the party moved on. Facebook has become much more of a utility and communications vehicle.” MySpace became difficult to navigate and cluttered with pop-up ads of dubious value selling things like weight-loss products, while Facebook offered a simple, Google-like interface. One Myspace user who defected to Facebook said it became “amateurish” and “boorish.” She said, “Every time I logged on it was just messages from bands I barely heard of. Facebook allows you to actually connect with real people, rather than bands or celebrities.”

©pumkinpie/Alamy

Friendster’s demise began in 2009 when a change of interface and technical problems upset users while Facebook was on the rise. As one expert noted, Friendster imploded in a systematic way: first less-connected users left, lowering the benefits of staying to more-connected users, until the cascade of departures unraveled the site.

The events of 2011 were not what industry insiders had expected. In 2005, the newspaper conglomerate News Corporation bought MySpace for $580 million. Until April 2008, the number of MySpace users consistently exceeded the number of Facebook users. After the acquisition, News Corporation announced an ambitious revenue target of $1 billion. But to meet these goals, ads were accepted that made the site slow, buggy, and difficult to use. By 2011 MySpace was losing money and News Corporation sold it for $35 million, a 94% loss over 6 years.

Chris Wolfe, a founder of MySpace, tried to explain the reversals: “The paradox in business is, ‘When do you focus on growth, and when do you focus on money? We focused on money and Facebook focused on growing the user base and user experience.’” In contrast to MySpace, Facebook refused to be acquired by a larger company, allowing it to ignore revenue goals. That is, until 2012 when Facebook began a push to open its website to ads, provoking a backlash among users. Some observers have warned that Facebook could go the way of Friendster, as it has experienced a dramatic decline among younger users, who have switched to competitors like Snapchat, Instagram, Tumblr, and Twitter. Stay logged on, somewhere, for the outcome.

QUESTIONS FOR THOUGHT

  1. Question 16.9

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    Describe the nature of the externality in social media websites.
  2. Question 16.10

    ShdTus0HyYV72SvajjcOU9DryY2S86pZfTkEyMQJxC2RTn6qdA7X/c3kpDlSDRr0bvWeH0u1Hf7zqlopsHXy/E/UWKzWO2j54CN/N0jismmEe+TwCkLsyyIgMZbmWaVnarw8cVfuy1lHNg5FpXU+w9jtnJT3hwb29RIwR4SlPMm+eBtpwm83jA3rdvj5R1EiJ5lg4pBvD3CLZgApPuiV3MUdmpcOH0Y7EgL5d7hBd+WcsbYmAtlYtMokKtGhtj+ZvaKuV/ttP8v8QIz+ZDQpMw==
    Assume that there are two competing social media websites. Explain why it is likely that one will come to dominate. Explain why the decline of a site is likely to be swift, with a cascade of departures.
  3. Question 16.11

    wOfzbvmvgPS/dm7KYGl67jAwhsCkUa7BmUD6iczQ/ts9c7Yj8s4XNg/bfQ2fPw0MkUtWw3/vkXWGd37TIROHbPWEJZ8f5wbR1adBTrh76RNFyaDb0RXd2H4LR60vC3l+VUwys63xH+UQYRZWgS9OsMnfaJaXf28i4AWDlRTUxl+ejI/vWiSA3/MnM4eUQgLC
    Explain the nature of the problem that undermined MySpace relative to Facebook. Is it unique to MySpace or common to all social media sites?