Postgraduate Diploma/Masters in Economics in Competition Law

POSTGRADUATE DIPLOMA/MASTERS IN ECONOMICS IN COMPETITION LAW

2008 / 2009

MODULE 2 – UNIT 7

Network Effects and Multi-Sided

Markets

AUTHOR

Dr Cento Veljanovski

Managing Partner, Case Associates

Associate Fellow

Institute of Advanced Legal Studies

University of London

1.INTRODUCTION3

2.NETWORK EFFECTS4

(A)Definitions and Concepts...... 4

(B)Features of Network Industries...... 6

(C)Competitive Effects...... 7

(D)Tipping...... 12

(i)Tipping and Network Size...... 12

(ii)Conditions for Tipping...... 16

(A)Case Studies...... 17

(i)Standards...... 17

(ii)Mergers and Joint Ventures...... 21

(iii)Mobile Termination...... 26

(iv)Mobile On and Off – Net Prices...... 30

Summary: Chapter 2...... 33

3.TWO-SIDED MARKETS34

(A)Introduction...... 34

(B)Definition...... 34

(C)Competitive Implications...... 36

(D)Market Definition...... 37

(E)Credit Card Networks...... 38

(i)Nature of Credit Card Networks...... 39

(ii)Interchange Fees...... 40

(iii)Market Definition...... 41

(iv)Interchange Fees...... 44

(v)Card Surcharges...... 44

(F)Microsoft and Bundling...... 46

Summary: Chapter 3...... 48

Further Reading...... 49

Biographical Details...... 51

Declaration...... 52

Questions...... 53

Model Answers to Questions in Unit 6...... 54

©Copyright Cento Veljanovski, 2008. All rights reserved.

No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, scanning, recording or by any information storage or retrieval system, without the prior written permission of the author.

1.INTRODUCTION

7-001This unit focuses on demand-side network effects, or as they are sometimes called, demand-side economies of scale.

7-002Network effects, and the related concept of two (or multi) -sided markets, are playing an increasing role in competition law in the communications sector, computer hardware and software, Computer Ticketing Services (CRS), Automated Teller Machines (ATMs) and credit card schemes sectors to name a few; and also in the evaluation of mergers, industry standards, market structure and competitive behaviour.

7-003In this unit, the concept and application of network effects are examined in relation to competition law – Article 82 (abuse of a dominant position), Article 81 (agreement or understandings which prevent, or distort competition) – and the merger/joint venture regulation.

7-004Chapter 2 begins by defining network effects and the way they alter the economics of market structure, competitive behaviour and pricing. The theory is then applied to concerns over the adoption of industry and product standards, mergers in the communications sector, and the pricing of mobile services.

7-005Chapter 3 deals with two-sided markets. This covers situations where network effects affect consumers in different groups or sides of the market brought together by a third party, such as credit card schemes. The theory of two-sided markets is developed and then applied to some features of credit card schemes which have been the subject of recent competition investigations.

2.NETWORK EFFECTS

(A)DEFINITIONS AND CONCEPTS

7-006Economics typically deals with one-sided markets where a consumer’s purchase of goods and services is independent of the amount or purchases of other individuals. This assumption is often reasonable and simplifies the analysis. However, for many products the demand of one or more customer groups is interrelated. This gives rise to a network externality or effect.

7-007At its simplest, a (direct) network effect is where the utility that a user derives from the consumption of a good increases with the number of other users consuming the same good.1

7-008McKnight and Bailey offer such a definition:

“A network externality is the benefit gained by incumbent users of a group when an additional user joins the group. The group can be thought of as a ‘network’ of users, hence the term network externality.”2

7-009The concept has been called a demand-side economy of scale, because the value of a network increases with the number of other subscribers accessible by the network.3

7-010The literature often refers approvingly to Metcalfe’s Law which states that the “value” of a network increases geometrically with the number of people who use it. However, while this captures the proposition being made, Metcalfe’s Law is not an economic law since it assumes a fixed relationship between uses and user benefits, which as we shall see does not necessarily exist.

7-011Farrell and Klemperer4 define network effects in terms of both total and marginal effects. Total effects occur when a subscriber’s adoption of a good benefits other adopters. Marginal effects, which are often overlooked in the literature, occur when a subscriber’s adoption increases the incentives of others to adopt. The two effects need not operate concurrently. For example, only marginal effects occur when a merchant chooses to accept credit cards.

7-012Tirole, on the other hand, provides a more general definition of a network effect:

“Positive network externalities arise when a good is more valuable to a user the more users adopt the same good or compatible ones. The externality can be direct (a telephone user benefits from others being connected to the same network; computer software, if compatible, can be shared). It can also be indirect; because of increasing returns to scale in production, a greater number of complementary products can be supplied – and at a lower price – when the network grows (more programs are written for a popular computer; there are more video-cassettes compatible with a dominant video system; a popular automobile is serviced by more dealers).”5

7-013This follows Shapiro and Katz6 who identify two types of network effects – direct and indirect:

•Direct Network Effects

Direct network effects have been defined above as occurring when the value of the service increases with the number of users/consumers. The more people with telephones, the more useful and the more valuable are telephones to the user. Direct network effects are relevant for two-way telecommunications systems such as fixed and mobile networks, the Internet, Instant Messaging and other communications networks.

•Indirect Network Effects

Indirect network effects occur when the value a consumer derives from a good or service increases with the number of additional users of identical and/or interoperable complementary goods. These give rise to what some have referred to as “virtual” or “hardware/software” networks. An example of an indirect network effect is a computer operating system. If only five people use the same operating system, few would write any programs and applications for that system, which would limit its usefulness. But as more people purchase that same operating system, programmers will create more programs for that system, increasing its usefulness. This will attract more users and begin to generate positive feedback effects that increasingly make the operating system more attractive to both programmers and users.

7-014The literature has more recently identified a third type of “network effect”:

•Induced Network Effects

Induced (endogenous) network effects are a pricing phenomenon created by charging a cheaper price for calls on the customers own network (on-net) than for calls to other networks (off-net). Cheaper on-net calls will be attractive to those subscribers who have a significant number of callers on the same network, and will encourage subscriptions to those networks. Further, cheap on-net calls increase switching costs, and thus give an advantage to the larger network (see below).

7-015Several other concepts are relevant to the analysis of network industries and effects:

•Externality

An externality exists if a transaction or action which imposes a cost or benefit on others is not taken into account by the transacting parties. The classic case of a negative externality or external cost is pollution where the production of a good (for example, electricity from a power generation plant) gives rise to third party effects (such as carbon emissions) not directly priced in the market and, therefore, not affecting the economic decisions of producers and consumers of electricity. As a result, the activity in question is over-expanded because the costs imposed on third parties (local residents) and others are ignored.

•Public Good

Another demand-side concept is a “public good”. A public good exists where the consumption by one individual does not detract from the consumption of others. A film or an episode of Friends is “public” in the sense that consumption is collective and indivisible – a broadcast can be watched by any one individual in the transmission area without preventing others from watching. It differs from consumption of an apple – a private good – which once eaten is unavailable to the rest of the world. Television programmes, computer software, music, most media and information products, intellectual property rights, and industry and technical standards all have public good characteristics. While the notion of a public good is a demand-side concept arising from the indivisibility of consumption, it has a supply-side counterpart. Public goods imply that the marginal costs of supplying the good or service to more users are low or negligible, and the average costs decline over the number of users. An episode of Friends has a large sunk cost of production which does not vary with the number of times it is broadcast or the size of its audience. This, in turn, gives rise to the existence of large sunk costs and products where marginal costs are below average (total) costs (see Section (B) below).

A Note on Terminology

7-016It is a misnomer to refer to network effects as an “externality”. This is because an external benefit (positive externality) or cost (negative externality) does not influence the actions of those who make resource allocation decisions, and implies market failure. A network effect as defined above is often taken into account by network operators who gain by “internalising” it, either by growing or interconnecting physical networks, or adopting pricing and marketing strategies which seek to rapidly grow the number of users and a product’s diffusion in the marketplace. Therefore, it is wrong to characterise many network effects as externalities, and hence to imply market failure. This is why the neutral term “network effect” has been adopted in much of the literature, and here.

(B)Features of Network Industries

7-017While this unit will focus on the demand-side features of network products, these do not occur in isolation, nor can the competitive issues be analysed without taking account of the other special features of networks and network industries.

7-018The concept of a network has typically been confined to physical networks such as telecommunications, gas, electricity and transport networks which involve either one-way or two-way flows of services over complementary physical networks.

7-019The network effects literature expands the notion of a “network” to include financial and virtual networks. A “virtual network”, has been defined as “a collection of compatible goods that share a common technical platform.”7

7-020Networks have special supply-side features arising from the complementarity between networks and their cost structures.

7-021In network industries, co-operation is often necessary to facilitate competition and promote efficiency.8 This may occur at a basic level where the upstream network provider supplies a critical input to firms which compete with its downstream activities. Or, the co-operation can be more extensive in order to agree an industry standard to interconnect networks, or to give access to codes and switches to enable interconnection and inter-operability. Clearly, this co-operation can go beyond that necessary to restrict competition unduly, or the failure to co-operate can be anti-competitive since it forecloses the market to potential competitors.

7-022The cost structure of networks is characterised by economies of scale and scope – or more accurately sub-additive cost functions over a large range of output.9 This means that there are:

•a high proportion of fixed to variable costs;

•declining average and marginal costs (due to scale effects and economies of density); and

•economies of scope – where the network produces a number of services (multi-product) it may be cheaper to supply two or more services together than each service separately.

(C)Competitive Effects

7-023As a result of these supply and demand conditions, the basic economic features of network industries differ.

7-024This can easily (if slightly inaccurately) be illustrated by comparing the demand and supply characteristics of a non-network industry, say for the production of the mythical widget, with one which has both supply-side and demand-side economies of scale.

7-025Figure 1 on the following page shows the supply and demand schedules for a standard good (a widget).

7-026The (market) demand schedule is downward sloping indicating that as output expands individuals with lower willingness to pay must be induced to buy additional units. The marginal cost (MC) schedule is either upward sloping or constant indicating that the additional costs of production are rising or constant respectively. This gives a determinate, stable outcome (equilibrium) where price (Pc) equals marginal costs under conditions of perfect competition. Indeed, the condition that price equals marginal costs provides one of the conditions for allocative efficiency, and the outcome of a perfect competitive market.

Figure 1

The Widget Market

7-027On the other hand, the schedules for a network industry are almost the reverse of those just described (Figure 2). If the industry has large fixed costs, marginal (and average) costs will decline. As a result the marginal costs (=supply) schedule will be negatively sloped, not a horizontal line or upward sloping. The presence of significant network effects means that the “demand curve” will rise as the network grows. This is because, as more users are added to the network, its value to the existing users rises (but see below for the more general case). As a result the demand and supply relationships are the reverse of those in ordinary markets. That is, Willingness to Pay (WTP) rises with “output” while unit costs fall. Economists refer to this more formally as “increasing returns”.10

7-028In such a market, the intersection of “demand” and “supply” schedules no longer generates a stable solution or a determinate price. In Figure 2, to the left of the intersection the network is unstable pushing it back to extinction. This is because marginal costs are higher than the “marginal value” that users place on the network. This would imply that the equilibrium is at zero output, i.e. no market. However, Figure 2 indicates another outcome. As output moves beyond the intersection of the two schedules (labelled as critical mass) users are prepared to pay much more for a unit expansion in the network than the costs of making that expansion. A network operator would realise this and be encouraged to expand the network even though during the early phases of development it is sustaining losses. As drawn, the network would supply the whole market because of the assumption of (linearly) increasing marginal WTP as the network expands.

Figure 2

The Network Goods Market

7-029The network literature emphasises the notion of a “critical mass”. This is depicted in Figure 2 by the intersection of the two lines. At this intersection unit costs equal the marginal valuation, and to the right the network is characterised by ever increasing net consumers’ surplus. The consequence is a tendency for successful networks to grow significantly as consumers’ value them more than smaller networks once they have achieved critical mass.

7-030As a result of these demand and supply features, many standard efficiency conditions alter:

•The first and most obvious difference is that monopoly may be a natural market outcome. If network effects are significant, the dynamics of the industry will encourage operators to grow their network rapidly. Consumers will be attracted to the larger network because they value large networks more than smaller networks. This effect will be reinforced if there are supply-side economies of scale which give larger networks lower unit costs.

•Second, such monopolies are “efficient”. Network growth driven by attempts to internalise network effects increases consumers’ welfare as measured by the economists’ concept of consumers’ surplus. Consumers’ surplus is the difference between what individuals pay for a good and their maximum willingness to pay at different levels of consumption. It gives a monetary value to consumer welfare.

A network operator has an incentive to grow the network, and in particular to encourage take-up in the early years, by so-called “penetrative pricing”. Since larger networks generate greater consumer benefits than smaller networks, this outcome is economically efficient, provided the larger network does not misuse any market power. Society is better off with these larger networks because the value to consumers is greater than would be the case if the same number of subscribers were spread among two or more incompatible smaller networks. In addition, the costs of developing the second (smaller) network are avoided. Indeed, from the assumption of declining unit costs and growing marginal benefits, such monopolies both maximise consumer surplus and are productively efficient (natural monopoly).

•However, the choice of network need not be efficient. For example, when consumers are locked into a network, an alternative network which offers a superior service will not be able to dislodge the larger established network. This “path-dependence” can see early developers of technology gain first-mover advantages through bandwagon effects and become dominant by capturing new growth so that an inefficient solution is adopted.

•Third, seeking to encourage competition in situations where there are significant network effects will reduce, not increase, consumer welfare and allocative efficiency. It may also not be possible given that market forces will constantly push toward the development of larger networks, while smaller networks will be at a competitive disadvantage.

7-031Network effects and supply factors also have implications for optimal pricing:

•First, the rule that price equal marginal costs is no longer efficient for network industries. This is because if firms price at marginal cost, they will not be able to cover their (often large) fixed costs. Also, as explained below, marginal cost pricing does not internalise the network effect and so leads to too few consumers. There will need to be mark-ups over marginal costs to cover fixed costs and network effects (the latter for services that have relatively inelastic demand).

•Second, the optimal pricing structure will be discriminatory, i.e. different prices to different consumers or groups of consumers which do not reflect cost differentials or even objective factors. These price differentials will be based on the different elasticities of groups of consumers and will be designed to internalise positive network effects.