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Network externality has been defined as a change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes. As fax machines increase in popularity, for example, your fax machine becomes increasingly valuable since you will have greater use for it. This allows, in principle, the value received by consumers to be separated into two distinct parts. One component, which in our writings we have labeled the autarky value, is the value generated by the product even if there are no other users. The second component, which we have called synchronization value, is the additional value derived from being able to interact with other users of the product, and it is this latter value that is the essence of network effects. An illustration: As this article was being written, commentators are speculating on whether Apple computer will survive, since its network (base of users) is shrinking, some think, below a minimum acceptable level. Since the actual quantity of Apple computers sold is still among the very largest of personal computer manufacturers which should allow Apple to take advantage of economies of scale in production, and the computers are not thought to be deficient in terms of quality, any lack of viability must be due to the fact that the network of Apple computer users is small. In other words, the synchronization value of Apple computers is thought to be too low. First a definitional concern: Network effects should not properly be called network externalities unless the participants in the market fail to internalize these effects. After all, it would not be useful to have the term ‘externality’ mean something different in this literature than it does in the rest of economics. Unfortunately, the term externality has been used somewhat carelessly in this literature. Although the individual consumers of a product are not likely to internalize the effect of their joining a network on other members of a network, the owner of a network may very well internalize such effects. When the owner of a network (or technology) is able to internalize such network effects, they are no longer externalities. This distinction, first discussed in Liebowitz and Margolis (1995) now seems to be adopted by some authors (e.g. Katz and Shapiro 1994) but has not been universally adopted. Putting aside definitional concerns, the import of network effects comes largely from the belief that they are endemic to new, high-tech industries, and that such industries experience problems that are different in character from the problems that have, for more ordinary commodities, been solved by markets (Katz and Shapiro 1985, Farrell and Saloner 1985, Arthur 1996). The purported problems due to network effects are several, but the most arresting is a claim that markets may adopt an inferior product or network in the place of some superior alternative. Thus if network effects are a typical characteristic of modern technologies, the theory suggests that markets may be inadequate for managing the fruits of such technologies. The concept of network externality has been applied in the literature of standards, where a primary concern is the choice of a correct standard (Farrell and Saloner 1985, Katz and Shapiro 1985, Besen and Farrell 1994, Liebowitz and Margolis 1996). The concept has also played a role in the literature of path dependence (Arthur 1989, 1990, David 1985, Liebowitz and Margolis 1990, 1995a.).
Once network effects were embodied in payoff functions. lead us to inappropriate or premature conclusions. Improvements in production costs. . It is now generally agreed (Katz and Shapiro. this literature has focused primarily on selection among competing networks. We briefly consider the issue of levels of network activities in section two. and thus repeat. Indirect network effects generally are pecuniary in nature and therefore should not be internalized. these production costs may overturn other natural monopoly elements. Our discussion below follows this relative emphasis. toner cartridges) are more readily available or lower in price as the number of users of a good (printers) increases. As we have noted above. The enthusiasm for recognizing and understanding these phenomena should not. and Ellis and Fellner (1943). may have more to do with being smarter than with being bigger. Finally. as with many other economic results. and differences in tastes. the ability of large consumers to selfinternalize network effects. Even for the set a real externalities. The first and broadest is that between network effects and network externalities. whereas they do impose (monopoly or monopsony) losses if internalized. The popular and very compelling example is the telephone network. In early writing. Instead. however. If these products have diseconomies of scale at some production level. Contemporary technologies expand that example enormously. we would urge some reservation about the empirical validity of economies of production scale for many high tech products. the likely symmetry of network effects for alternative products. 1994) that the consequences of internalizing direct and indirect network effects are quite different. then turn to the choice of networks. A further distinction is between pecuniary externalities and real ones. Pecuniary externalities do not impose deadweight losses if left uninternalized. (For the resolution of pecuniary externalities see Young (1913).) Concern about marginal adjustment of the level of network activity has not been the primary focus of the network externality literature. however. earlier mistakes regarding pecuniary externalities. it is important to note the distinction between the problem of network size and that of network choice. Conclusions Network effects are undoubtedly real and important phenomena. However. An interesting aspect of the network externalities literature is that it seemed to ignore.The literature has identified two types of network effects. this distinction was not carried into models of network effects. our 1994 paper demonstrates that the two types of effects will typically have different economic implications. Direct network effects have been defined as those generated through a direct physical effect of the number of purchasers on the value of a product (e. Who would deny that the value of phone service depends heavily on the number of other people who have phone service. Knight (1924).g. fax machines). Indirect network effects are "market mediated effects" such as cases where complementary goods (e. the boundedness of the network effect. there are distinctions and reservations that ought to be maintained.g. any distinction between direct and indirect effects was ignored in developing models and drawing conclusions.
The lines represent potential calls between phones. where more users make a product less valuable. but are more commonly referred to as "congestion" (as in traffic congestion or network congestion). a network effect (also called network externality or demand-side economies of scale) is the effect that one user of a good or service has on the value of that product to other people. The classic example is the telephone.In economics and business. Over time. Online social networks work in the same way. Negative network externalities can also occur. When network effect is present. Diagram showing the network effect in a few simple phone networks. The more people own telephones. . but does so in any case. with sites like Twitter and Facebook being more useful the more users join. This creates a positive externality because a user may purchase a telephone without intending to create value for other users. the more valuable the telephone is to each owner. in a positive feedback loop. positive network effects can create a bandwagon effect as the network becomes more valuable and more people join. The expression "network effect" is applied most commonly to positive network externalities as in the case of the telephone. the value of a product or service is dependent on the number of others using it.
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