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Network effects and two sided marketsOFT lecture - 16th of January, 2007
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Alexia Gaudeul
University of East Anglia andESRC Centre for Competition Policy
Plan of the presentation
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Two parts: Network effects and Two-sided markets
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In each part
DefinitionMotivation / ApplicationModels with basic concepts and logicPolicy implicationsReview of required reading
 
Method of presentation
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Theoretical models to understand the mechanisms of competition in the specific setting under study.
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Application of theory to draw out policy implications
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Work required:
Work out models on your own to assimilate their logic.Read the required readings!
Network effects
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Def: A change in the benefit, or surplus, that an agent derives from agood when the number of other agents consuming the same kind of goodchanges.
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Spreadsheets (Brynjolfsson and Kemerer 96):1% increase in installed base means a 0.75% increase in priceProducts that adhere to the standard get 45% higher price
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Network equipments (Forman 01 and Forman and Chen 03)Firms are able to exploit cross-product and cross-firm switching costs toinduce strong legacy effects and lock-in.Compatibility is a strategic variable in firms’ product design
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DVD vs DIVX war (Dranove and Gandal 03)
 
Rational expectations and multipleequilibria: Katz and Shapiro (85)
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Duopoly with two incompatible products.
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Consumer of type z gets utility v(qi)+z from network i=1,2 of size qi.
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Net utility: u(z)=v(qi)+z-pi
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Net price: Pi=pi-v(E(qi))
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All consumers choose the network which net price is the lowest. For bothfirms to survive, I must thus have P1=P2=P
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The choice thus depends on the expectations of the consumer.
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If z is uniform over [0,1], thenz>P buy one of the goods andTotal demand is q=1-P= q1+q2=1-pi-v(E(qi)), i=1,2
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Profit is then qi(pi-c). One obtains reaction functions and a Nashequilibrium, with the requirement that E(qi)=qi in equilibrium (rationalexpectations).
Rational expectations and multipleequilibria (suite)
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Competing for the market, or competing in the market(standardization)?
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What drives expectations?
Chicken and egg problem: low price to encourage adoption, highprice to exploit adoption...
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Pricing for progressive adoption (subsidy then exploitation of the user base)
Do consumers anticipate this potential lock-in problem?
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