TOPIC 10.

NETWORK
EXTERNALITIES
[BM] Chapter 9.

Homework due this Friday 18.00

in front of Konstantins office 20.148

OBJECTIVES OF
EXPERIMENT
In this experiment we expect that students will
accomplish the following:
Learn the definition of network externalities and be
able to identify examples from the real world.
Observe the dynamics of externalities in a
competitive market and understand that new
technologies often need to reach critical mass.
Learn about competing standards and be able to
identify examples from the real world.
Learn about Lock-in effects and their impact on the
dynamics of industries.
See that the economic principles that they have
learned apply to industries with exciting new
technologies as well as to more established ones.

9.1 WHAT ARE THE NETWORK

EXTERNALITIES?
Definition:
It is said that a product has network
externalities if the purchase value for
those consuming is greater the higher the
total number of consumers who consume
the product.
Examples:
Communication: telefone networks
Infrastructure: xls convertable in all other
programs
Facebook

QUESTIONS:
How can we analyze a market with
network externalities?
Can we still use supply and
demand?

THE DEMAND CURVE WITHOUT

NETWORK EXTERNALITIES (REVISION)
We obtain the quantities demanded for each
price level.
Number
of
agents

Value

15

30

15

10

Prices

P> 30

P
30

20

Quantities

10

10 <P <30

15

P <10

30
15

30

 But we could also get

which is the highest price at which each amount is
demanded.
P
Number
of
agents

Value

15

30

15

10

Prices

Quantities

30

0 <Q <15

10

15 <Q <30

P <10

Q = 30

30

10

10

15

20

30

 Define P(q) as q highest purchase

value.
What isPthe
(q) highest price to be paid
for q units?
The function P(q) is known as the
inverse demand function.
th

For 110 units 8 is the highest price

Demand
Function

Price

Inverse demand
function

110

180
Amount

How do we construct a demand curve with network externalities?

We need to know the Buyer value of each additional entrant, which however, depends on
the number of buyers who have already entered before the person we are considering for
entering.

9.2 THE DEMAND CURVE WITH NETWORK EXTERNALITIES.

EXAMPLE 1. (DISCRETE CASE)

Inital value

Number of
buyers

Number of
units sold

Factor
Externality

1-6

7-12

13-18

19-24

25-30

If q demanded is between 1-6, then externality is 1;

Buyer Value is Initial value* externality factor =
5=1*5 (with Initial Value=5)
(p(q) is willingness to pay of people with initial value 5 and q
qbetween
demanded
1-6). is between 7-12, p(q) = 8=2*4.

If
In other words: In order to get between 7 and 12 people
to buy, the price cannot be higher than 4
If q demanded is between 13-18, p(q) = 9=3*3.

If q demanded is between 1-6, p(q) = 5.

If q demanded is between 7-12, p(q) = 8.
If q demanded is between 13-18, p(q) = 9.
If q demanded is between 19-24, p(q) = 8.
If q demanded is between 25-30, p(q) = 5.

Number of
units sold

highest
price

1-6

1*5=5

7-12

2*4=8

13-18

3*3=9

19-24

4*2=8

25-30

5*1=5

p
9
8
5

There is no vertical
line since person 6
cannot pay a price
higher than 5

12

18 24

30

DEMAND CURVE:
B. THE DEMAND CURVE WITHOUT
REGRETS
(CONTINUOUS
CASE!)
Demand
= maximum
price to be paid for q units
P(q) = qth highest purchase value
Example:
100 companies have to decide whether to connect to a
videoconferencing network.
The purchase value of connecting to the corporate network
is different for each company. Order companies by q =
1, ..., 100. Say campany q has purchase value 100-q
(note that the initial value of firm q is here (100-q)), the
externality factor is number of firms connected.

(100 q ) number of firms connected

If company q expects exactly k firms (including himself) to

100 q k
connect it has value:

9.2 NETWORK EXTERNALITIES AND THE DEMAND CURVE:

B. THE DEMAND CURVE WITHOUT REGRETS

Demand = maximum price to be paid for q units

P(q) is qth highest purchase value
Company q always has the qth highest purchase
value. Therefore he knows that there are q-1
firms (before him) and including himself there
will be q firms to be the externality factor.

Therefore, the maximum price to be

2
paid forP(qq )units
is
(100 q ) * q 100q q

9.2 NETWORK EXTERNALITIES AND THE DEMAND

CURVE:
B. THE DEMAND CURVE WITHOUT REGRETS

P (q) 100 q q 100 q q 2

Demand curve
without regrets

If no one connects, the purchase value will be 0 for

all. Blue line part of demand curve

9.3 EQUILIBRIUM WITH NETWORK

EXTERNALITIES

nnection costs for company

=
3,000
2.100
onnection costs
=

Single
equilibrium:
0 C and D
3
equilibria: B,
Offer curve

9.4 STABLE EQUILIBRIA, UNSTABLE

EQUILIBRIA AND CRITICAL MASS
Are all equilibria equal?
Let us study their dynamics
How does the market work out of equilibrium?

STABLE EQUILIBRIUM:
when there are small deviations there is a return to
equilibrium.

UNSTABLE EQUILIBRIUM:

when small deviations occur, the dynamics go further away from it.

q=10 P(q) = 900 (see function slide 12)<2,100.

Company 10 abandons.
The same reasoning for q <30 and q> 70
For 30 <q <70, P(q)> 2,100, and these companies are
connected because there are q companies already
connected.

Equilibrium C is unstable
Equilibria B and D are stable
Of the stable equilibria, D has more total benefits
than B
To achieve equilibrium D we would only need a
critical mass of 31 companies to connect.

SUMMARY
When the purchase value of a consumer
depends on the number of consumers buying
the good we say there are network
externalities.
In the presence of network externalities we
build demand without regrets.
Generally we will have several equilibria:
some will be stable and others unstable.
To achieve the highest stable equilibria, it is
necessary to achieve critical mass.

SUMMARY
Understand the concepts allows us to use them in
different contexts
o When we have network externalities, the demand curve
does not have a negative slope, yet it still represents the
same as without network externalities.

Some times we have a specific prediction (a

unique equilibrium). In other cases, the only thing
we can say is that there is a set of potentital
results.
o With network externalities, we have multiple equilibria;
overlapping supply and demand curves.

SUMMARY
Whenever we have a set of predictions (equilibria), we
can sometimes use a different criteria to determine
the likelihood that each of the equilibria takes place
o For example, its stability.

Finally, in this course, we have focused a lot on

efficiency. However, efficiency is one (important) part
of the whole picture.
Methodologically, we have looked at extreme cases:
perfectly competitive markets, monopolies, goods that
are perfetly complements or substitutes,
externalities

RECOMMENDATIONS AND HW
Recommendations:
Read Topic 9 in [BM]
Do exercises 9.1-...-9.6.

Hand in HW#7:
* in front of door Konstantins office
20.1

FINAL EXAM

Monday December 15th, 11:30am 1:30pm.

Be on time, bring a pencil, your

Identification card

THANKS FOR BEING

GREAT CLASS, AND
PLEASE, STAY IN
TOUCH!