NETWORK EXTERNALITIES - BS ENTREPRENEURSHIP.pdf

EXTERNALITIES

1. NETWORK
EXTERNALITIES
MANAGEMENTOFTECHNOLOGY
By: Flor Arquillano Slide 1

2. Chapter 4 Slide 2
Network Externalities

Network externality, also known as
network effects, is an economic
theory that describes how the
value of a product or service
increases as more people use it.
It's a fundamental concept in
business strategy and is especially
relevant for digital technologies and
telecommunications

3. Chapter 4 Slide 3
Network Externalities

Essentially meaning that the greater
the network of users, the more
beneficial it becomes for each
individual within that network; a
classic example being the telephone
system.

4. Chapter 4 Slide 4
How does it work?

Autarky value: The value of a
product even if no one else uses it

Synchronization value: The
additional value of being able to
interact with other users

5. Chapter 4 Slide 5
How does it work?

This term originates from the Greek
word "autarkeia" meaning self-
sufficiency. In the context of
technology, it refers to the individual
utility a product provides without
relying on others using the same
produc

6. Chapter 4 Slide 6
How does it work?

This is the added benefit that arises
when multiple users adopt the same
product, allowing them to interact and
share functionalities within a
network.

7. Chapter 4 Slide 7
Example:

Social media platforms:The
"autarky value" could be the ability to
post personal updates on your own
timeline, while the "synchronization
value" is the added benefit of
connecting with friends, seeing their
posts, and interacting through
comments and likes.

8. Chapter 4 Slide 8
Examples

Fax machines

As more people use fax machines, your
fax machine becomes more valuable
because you'll use it more

Social media

If your friends are on Facebook, you
might join so you can connect with them

9. Chapter 4 Slide 9
Examples

Online services

As more people use online services like
Google, the service improves and more
companies offer products and services

10. Chapter 4 Slide 10
Other Applications

The number of DVD titles available
for rental increases as more people
buy DVD players

The utility of a communications
service increases as more people
join the system

11. Chapter 4 Slide 11
Network Externalities

Up to this point we have assumed
that people’s demands for a good are
independent of one another.

If fact, a person’s demand may be
affected by the number of other
people who have purchased the
good.

12. Chapter 4 Slide 12
Network Externalities

If this is the case, a network
externalityexists.

Network externalities can be positive
or negative.

13. Two Types of
Network
Externalities
Chapter 4 Slide 13

14. Chapter 4 Slide 14
Types of Network Externalities

A positive network externalityexists if
the quantity of a good demanded by
a consumer increases in response to
an increase in purchases by other
consumers.

Negativenetwork externalities are
just the opposite.

15. Chapter 4 Slide 15
PositiveNetworkExternality

positive network externalities" occur
when the value increases as more
people use it

when a person or group benefits from
another person's actions without
receiving compensation. Positive
externalities can occur in production
or consumption

16. Chapter 4 Slide 16
Characteristics of positive externalities

They are a form of market failure.

They can arise on the production or
consumption side.

They are likely to be underproduced
because the parties involved receive
no compensation.

17. Chapter 4 Slide 17
Examplesof positive externalities

Vaccinations: When someone gets
vaccinated, they prevent others from
getting sick

Streaming services: Companies pay for
ads, which allows many streaming
services to be free to the public.

Innovation: New innovations often benefit
many people, not just the person or
company that invented them

18. Chapter 4 Slide 18
NegativeNetwork Externality

occur when too many people use a
good or service, which can lead to
congestion and reduced quality of
service.

19. Chapter 4 Slide 19
NegativeNetwork Externality

When too many people use a
service, it can slow down servers or
production.

Companies may incur high costs to
meet demand.

Companies may become less
innovative over time.

20. Chapter 4 Slide 20
Characteristics of negativeexternalities

Negative externalities are a form of market
failure that can lead to inefficient market
outcomes. For example, if a factory
pollutes the air, society pays for the cost of
health problems caused by the pollution.
This means that the firm's profits are
higher than they should be, and there is
more pollution than there should be.

21. Chapter 4 Slide 21
Examples of negativeexternalities

An overcrowded communication network
can lead to congestion and reduced
service quality.

A crowded highway where traffic
congestion reduces the value of each
individual's travel time

As more users join, the quality or usability
of the product or service declines for
existing users

22. Chapter 4 Slide 22
Examples of negative externalities

Air pollution

Factories release harmful gases that damage
crops, buildings, and human health

Water pollution

Industrial wastes pollute public waterways,
harming humans, animals, and plants

23. How does technological
innovation affect network
externalities?
Chapter 4 Slide 23

24. Chapter 4 Slide 24
How does technological innovation affect network
externalities?

Technological innovation can significantly impact
network externalities by either enhancing or
diminishing the value of a product or service
based on the number of users, often leading to
rapid adoption when new innovations are
compatible with existing networks and create
positive network effects, while incompatibility can
hinder adoption and create barriers to entry for
new technologies

25. Chapter 4 Slide 25
Keypoints:

Positive network effects:

When a new innovation increases the value of
a product or service as more people adopt it,
creating a positive network externality. For
example, a new social media platform
becomes more valuable as more friends join,
encouraging further adoption.

26. Chapter 4 Slide 26
Keypoints:

Compatibility is crucial:

If a new innovation is compatible with existing
networks and standards, it can quickly benefit
from existing network externalities,
accelerating adoption.

27. Chapter 4 Slide 27
Keypoints:

Lock-in effects:

Established technologies with large user bases
can create "lock-in" effects, making it difficult
for new, even superior technologies to gain
traction due to the existing network's value.

28. Chapter 4 Slide 28
Keypoints:

Innovation race:

Companies often compete to develop
innovative technologies that can capture the
largest market share by leveraging network
externalities, potentially leading to rapid
innovation cycles

29. Chapter 4 Slide 29
Examples:

Smartphone operating systems:

The dominance of iOS and Android creates a
strong network effect due to app compatibility,
making it difficult for new mobile operating
systems to gain significant market share.

30. Chapter 4 Slide 30
Examples:

Cloud computing services:

As more businesses use a specific cloud
computing platform, the value of the platform
increases due to improved interoperability and
access to services.

31. Chapter 4 Slide 31
Examples:

Early adopter dilemma:

When a new technology is initially adopted by
a small group of users, it may not reach critical
mass and fail to gain widespread adoption due
to limited network effects

32. Chapter 4 Slide 32
Network Externalities

The Bandwagon Effect

This is the desire to be in style, to have
a good because almost everyone else
has it, or to indulge in a fad.

This is the major objective of marketing
and advertising campaigns (e.g. toys,
clothing).

33. Chapter 4 Slide 33
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20 40
When consumers believe more
people have purchased the
product, the demand curve shifts
further to the the right .
D
40
60
D
60
80
D
80
100
D
100

34. Chapter 4 Slide 34
Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20406080100
D
40
D
60
D
80
D
100
The market demand
curve is found by joining
the points on the individual
demand curves. It is relatively
more elastic.

35. Chapter 4 Slide 35
Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20406080
100
D
40
D
60
D
80
D
100
Pure Price
Effect
48
Suppose the price falls
from $30 to $20. If there
were no bandwagon effect,
quantity demanded would
only increase to 48,000
$20
$30

36. Chapter 4 Slide 36
Demand
Positive Network
Externality: Bandwagon Effect
Quantity
(thousands per month)
Price
($ per
unit)
D
20
20406080
100
D
40
D
60
D
80
D
100
Pure Price
Effect
$20
48
Bandwagon
Effect
But as more people buy
the good, it becomes
stylish to own it and
the quantity demanded
increases further.
$30

37. Chapter 4 Slide 37
Network Externalities

The Snob Effect

If the network externality is negative, a
snob effectexists.

The snob effectrefers to the desire to
own exclusive or unique goods.

The quantity demanded of a “snob”
good is higher the fewer the people
who own it.

38. Chapter 4 Slide 38
Negative Network
Externality: Snob Effect
Quantity
(thousands
per month)
Price
($ per
unit)
Demand
2
D
2
$30,000
$15,000
14
Pure Price Effect
Originally demand is D
2
,
when consumers think 2000
people have bought a good.
468
D
4
D
6
D
8
However, if consumers think 4,000
people have bought the good,
demand shifts from D
2
to D
6
andits
snob value has been reduced.

39. Chapter 4 Slide 39
Negative Network
Externality: Snob Effect
Quantity
(thousands
per month)
2468
The demand is less elastic and
as a snob good its value is greatly
reduced if more people own
it. Sales decrease as a result.
Examples: Rolex watches and long
lines at the ski lift.
Price
($ per
unit)
D
2
$30,000
$15,000
14
D
4
D
6
D
8
Demand
Pure Price Effect
Snob Effect
Net
Effect

40. Chapter 4 Slide 40
Network Externalities and the Demands
for Computers and Fax Machines

Examples of Positive Feedback
Externalities

Mainframe computers: 1954 -1965

Microsoft Windows PC operating
system

Fax-machines and e-mail