ITR/PE (SES): Empirical Studies of Network Effects

Trustees Of Boston University, Boston

Investigators

Abstract

A network effect exists when an agent values a good based on how many other agents use the good. For instance, consumers choosing between VHS and Beta VCR's are unlikely to choose based on superior technical performance. Instead, consumers choose the standard that other consumers choose, most likely in order to have access to a large library of pre-recorded movies. Network effects are present in many markets and are especially important for many high technology and information technology goods. Network goods can lead to market outcomes that present difficult problems for public policy. This project studies two such outcomes: The first is that a market can coordinate on a single proprietary good, leading to market power for the owner of the good. The second is that markets can fail to coordinate, so consumers are unsure of which standard will ultimately be adopted. Such confusion can lead to very slow adoption rates for new products. This project analyzes two specific industries that exhibit these problems. The project works through estimation issues that arise in the face of network effects and uses the results of the estimation to analyze the implications for government intervention into those markets, either by antitrust or standard setting. The first part of the project estimates the importance of a positive feedback loop in the market for Yellow Pages advertising. I estimate how much consumers prefer directories with more advertising and how much advertisers are willing to pay to advertise in a directory with more readers. I use resulting estimates to consider whether the market benefits from monopoly (which takes advantage of network effects) or oligopoly (which reduces market power). The preliminary estimates imply that a more competitive market is preferable. This result supports recent policy promoting competition in the directory market. Furthermore, techniques developed here could be usefully applied to other markets. For instance, just as consumers and advertisers prefer to coordinate on a single directory, consumers and software developers prefer to coordinate on a single operating system. A drawback of my results from the Yellow Pages market is that the estimates predict unreasonably high benefits from adding directories to the market. This problem is a common one when using discrete choice models. The second part of this project (which is joint work with Daniel Ackerberg, UCLA) proposes a new estimator that captures the fact that as products enter a market, products become more similar with regards to characteristics that are unobservable to the researcher. Our research presents structural justifications of the estimator as well as Monte Carlo studies of when the estimator is most appropriate. This estimator has many applications, and the application of this technique to the Yellow Pages market should lead to more accurate estimates, both of the strength of the network effect and of the welfare tradeoffs between competition and standardization. The third part of the project is joint work with Angelique Augereau (McKinsey) and Shane Greenstein (Kellogg). We analyze the introduction of high-speed modems and how the market failed to coordinate on a single standard. Originally, two competing but equivalent standards of 56K modems led to a situation in which consumers and Internet service providers had to coordinate their choice of modem technology. Overall, adoption was very slow and eventually, an industry group developed a single standard that was widely adopted. Our explanation of the slow initial adoption rate is that, in contrast to the incentives to coordinate, ISP's also have an incentive to differentiate across the two standards because doing so reduces price competition. Consumers then postpone adoption because they do not know which standard will "win". We develop a theoretical model that formalizes these points. In addition, preliminary empirical analysis suggests that, before the arrival of the new standard, adopting ISP choices were evenly distributed between the two standards even within individual markets. As our theory predicts, ISP's perfectly differentiated instead of coordinated. We use insights and results from the study of this market to discuss the competitive determination of adoption choice and implications for the benefits of intervention into a standards war.