Lecture Managerial economics - Chapter 8: Network effect

Lecture Managerial economics - Chapter 8 presents contents: Motivation for network effect, network externality, source for network externalities, winner takes all, similar rationale: learning curve, lock-in,... Inviting you to refer.

Week Network Effect Motivation for Network Effect AOL, Yahoo, MSN and Google offer free instant messaging software • Clearly, not a profit maximizing strategy at least in the short run • Why would they set price = $0 and maximize the market share? Network Externality Network externality • if the number of consumers using the product increases the product’s demand –similar to positive externality –higher sales push demand curve out • Examples? – DVD players – video game systems (PS2) – Email – Fax machine –? Source for Network Externalities? need for a standard • Same platform to exchange “data” – MS Word software – DVD players – fax machines – language • industry standard for other products – operating systems – which side to drive on – 110 voltage If there’s a need for a standard, how many products (standards) will survive? Winner Takes All How many products will survive in a market? • Theoretically ONE, a natural monopoly –empirically, more than can survive because of different consumer tastes –but we expect dominant product/standard Implications of Network Externality for business strategy • there might be a first-mover advantage –a race for market share –become the standard –being the standard implies switching costs for your customers • justification for sacrificing short term profits in favor of long term profits Similar Rationale: Learning Curve Learning Curve: • Production cost gets lower over time b/c of experience from producing Implications for business strategy? • Lower price and produce more in the short run –Sacrifice short run profit • In long run, it can become the lowest cost provider What is the difference between learning curve and NE? • Learning curve : supply side effect, cost • NE : demand side effect, standard Lock-In Suppose • There are products: I (inferior) and S (superior) • There’s a significant network externality with these products If the inferior product entered the market first, • It may become a monopoly • The superior product gets no market share • We are stuck with inferior product Outcome is not optimal for the society = Lock in Examples of Lock-In (?) Possible lock-ins (?) • VHS v BetaMax • DOS v Macintosh • QWERTY v Dvorak keyboards • 110 voltage v 220 voltage (?) • Other example? Lock-in is only a theoretical prediction • Real evidence are hard to find • The above examples are not conclusive evidence for lock-ins Entrant with the Superior Product Attempt to unlock the Market • The firm producing superior product will fight for the market share Conditions to unlock • greater quality difference ⇒ easier to overcome • many potential buyers ⇒ easier to increase market share Business Strategy for the new entrant • Product differentiation • merger, if possible • temporary price cuts • further improvements in quality • lower switching cost for existing customers Business Strategy for the Incumbent If you are incumbent with inferior product, what is your business strategy? • Given rival’s strategy, the only way to sustain the market share is to improve the quality • Invest in R&D – Once invested, it will be sunk cost – Once sunk, this cost will not affect future decision – This is a leverage against new entry that must bear sunk cost in future • Lower price – Doesn’t work well 10 Empirical Evidence for Lock-ins Survival of the fittest • If the new product is superior, it will prevail eventually • The incumbent constantly improves its quality Empirical Evidence • Very hard to find a true example of lock-in – The incumbent that survived must have some advantage • It may happen to standards related with custom, culture – language (?) 11 Unlocking Examples Nintendo v SONY PlayStation Word Perfect v MS Word Quicken v MS Money (?) Other examples? •? 12 Summary Network Externality • Individual’s demand depends on others’ consumption Lock-In • Conditions – Significant network externality – Inferior product was the first mover • Result – stuck with the inferior product Empirical evidence • History tells superior product eventually overtakes the market • Evidence for lock-in is rare 13 Regulation, Public goods Three categories of government's role in the economy: Macroeconomic - Using fiscal (Congress) and monetary policy (Federal Reserve) to achieve macroeconomic goals of stabilizing the economy and promoting low unemployment, full output, stable prices, stabilize the business cycles, prevent recessions, etc Microeconomic - Provide public goods (national defense, FBI, police protection, fire departments, roads and highways, court system, patents, etc.) and regulate the economy (FDA, FTC, DOJ, FAA, zoning, etc.) Distributive - Redistribute income to reduce income inequality, improve the welfare of the poor, provide medical care (Medicare, Medicaid, VA hospitals), provide retirement income (Social Security) 14 The microeconomic role of Gov 1) improve upon potential market failures, inefficient production or consumption 2) provide the "optimal" amount of public goods and services that cannot be "provided" by the private sector 15 Market failures and regulation Market Failure due to monopoly Government responses to monopoly practices (Enforce antitrust laws): 1> Breaking up monopoly Examples: a> Standard Oil in 1911, 90% market share for oil & b> AT&T in 1982 for 100% of the telephone service 2> Preventing Monopolies from Arising 3> Preventing Mergers that Reduce Competition The government blocked the mergers of: a> Staples and Office Depot & b> Rite-Aid and Revco 4> Preventing Collusion a> Ivy League universities were forced to stop meeting and sharing information on tuition increases, faculty salaries and financial aid policies b> Archer Daniels Midland pleaded guilty to price fixing for food additives in the U.S with international competitors and it paid a $100m fine, the largest antitrust fine in history 16 Market failures and regulation Bottom line: Antitrust laws are complex, somewhat vague, confusing and controversial Controversy: "Chicago School" (laissez-faire) hands off approach vs pragmatic approach to antitrust enforcement Pragmatic Approach was more prevalent during Clinton's administration, using more of a case-by-case approach E.g., the Office Depot-Staples merger was challenged even though the combined firm would only have had 4% of the national office supply market 17 Market failure due to externalities Externalities (positive or negative) are secondary effects that have an impact on the well-being of nonconsenting parties Pollution: negative externality (spillover cost) Literacy/Education: positive externality (spillover benefit) Solution: Government action could improve upon the market outcome by: a) regulating the amount of pollution and b) requiring mandatory attendance in school and providing public education Remedying Externalities Solutions for externalities (negative) include: 1) government taxes, standards or permits for externalities like pollution, or 2) monetary payments between the affected parties by either bargaining (negotiation) or by court decisions Transferable Emissions Permits is another regulatory approach Subsidizing Positive Externalities , Promoting R&D and Patent system, and Regulatory Reform 18 Market failure due to imperfect information In reality there could be many cases of incomplete, misleading or inaccurate information about consumer products or services, leading to a potential role for government intervention to correct for market inefficiencies Example: Regulations for car companies including CAFE (corporate average fuel economy) standards Benefit-cost analysis (BCA) is a method of making decisions and evaluating public projects, programs, regulations, etc Any public decision can be guided by BCA 19 ... Learning curve : supply side effect, cost • NE : demand side effect, standard Lock-In Suppose • There are products: I (inferior) and S (superior) • There’s a significant network externality with... Lock in Examples of Lock-In (?) Possible lock-ins (?) • VHS v BetaMax • DOS v Macintosh • QWERTY v Dvorak keyboards • 110 voltage v 220 voltage (?) • Other example? Lock-in is only a theoretical... MS Money (?) Other examples? •? 12 Summary Network Externality • Individual’s demand depends on others’ consumption Lock-In • Conditions – Significant network externality – Inferior product was