Living Economics

Systems Competition and Network Effects
Katz & Shapiro
A dominant network based on a near universal standard can internalize a great deal of system externality to the benefits of network users and can persist even in the face of technically superior competing networks.

For many products, one consumer’s utility from using the products is not dependent on how many other consumers also use them. For other products, one’s choice of which products to buy and use critically depends on how many other consumers also use them. These products thus generate external effects that must be taken into account in consumer choice. One class of these products either shares the same universal standards or must be used in large networks. For example, computer networks and telecommunications systems are typical of these products. Three issues are involved in consumer choice (and thus producer choice) among systems: expectations, coordination, and compatibility.

In a communications network, the network is more useful the more users use it. In the case of a fax machine communications system, if each consumer expects no other consumer will purchase a fax machine, then no one will purchase it. On the other hand, if each consumer expects that a large number of other consumers are going to purchase fax machines, then many would purchase fax machines. This then is the pure expectation issue.

But hardware alone does not make a network work unless there is enough software to justify the purchase of the hardware. A firm contemplating whether to develop and release a new architecture of microprocessor, for example, must know whether software will be provided to work on the new microprocessor. Such coordination between producers of complementary products compounds the difficulty of consumer choice in adopting networked products.

Once the network achieves a threshold size, its continued expansion is built on the emergence of compatible products. The more compatible products there are, the bigger the network grows. And the bigger the network grows, the more compatible and cheaper products will be offered. This process of positive feedback is fueled by the increasing extent to which external benefits of individual adoptions can be internalized among users of the network. Thus, once a network has established its dominant position, any new products that are not compatible with this dominant network will be rejected no matter how technically superior they might be. Any new products incompatible with the dominant system must compete not with individual products of the dominant system, but with all the internalized benefits of an established system.

While internalized network externality is formidable, it is not unbreakable. One possibility is that the sponsor of a competing network can indirectly commit itself to a price path involving “competitive” second-period prices by opening the market to independent suppliers of complementary products. Another way is to commit a major asset to guarantee the viability of a competing system. Casual observation suggests that one reason that the IBM PC (a new system challenging the established CPM system) was so successful is that consumers expected the product to succeed since it was backed by the reputation of IBM!

References:
  • Katz, M.L. & C. Shapiro. 1994. “Systems Competition and Network Effects,” Journal of Economic Perspectives 8 (2): 93-115.
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