Network Externalities and the Coase Conjecture Robin Mason

Department of Economics, University of Southampton

11th November 1998

Abstract This paper addresses two general questions. First, what is the e ect of market structure on the development of a network in a dynamic model with rational expectations? Secondly, is the intuition that network externalities are `economies of scale on the demand side' correct? These questions are examined in a model of durable good production in the presence of network externalities. Two results are presented. First, the Coase conjecture fails in its strongest sense when network bene ts are increasing in the current network size. Secondly, a committed monopolist may be socially preferable to a time consistent producer when network externalities are suciently large. The analysis indicates an analogy between network externalities and learning-by-doing. JEL Classification: C73, C78, D42, L12. Keywords: Coase Conjecture, Network Externalities. Address for correspondence: Robin Mason, Department of Economics, Uni-

versity of Southampton, High eld, Southampton SO17 1BJ, U.K.. Tel.: +44 1703 593268; fax.: +44 1703 593858; e-mail: [email protected] Filename: COASENT8.tex.

 I would like to thank Larry Karp for many comments on various drafts which have improved

the paper substantially. Discussions with David Newbery and David Myatt have also been very helpful. Any errors are my own. Funding from Alcatel Bell is gratefully acknowledged. The latest draft of this paper can be found at http://www.soton.ac.uk/ram2/papers.html.

1. Introduction

This paper examines the production of a durable good in the presence of network externalities in order to address two general questions. First, what is the e ect of market structure on the development of a network in a dynamic model with rational expectations? Secondly, is the intuition that network externalities are `economies of scale on the demand side' correct? The paper brings together two sets of literature. The rst details the conditions under which the Coase conjecture can be expected to hold. Central to this work is a careful treatment of the time consistency issues that arise when a good is durable and consumers anticipate price changes in the future. The second considers the e ect that network externalities have on market outcomes. This research examines (amongst other issues) the tendency for concentrated industry structures when there are network e ects. While a few authors have suggested the importance of combining the two approaches, there has not yet been a satisfactory treatment of the problem of durable good sales with network externalities. It is now well-known that, under certain conditions, a durable good manufacturer who must choose price or quantity continuously loses all monopoly power; see Coase (1972) for the original statement of this conjecture and Bulow (1982) and Gul et al. (1986) for rigorous proofs. Intuitively, the monopolist at any point in time must compete with himself at each date in the future; so, as the length of each time period goes to zero, the monopolist faces an in nite number of competitors and therefore loses all monopoly pro ts. The Coase conjecture has consequences for equilibrium dynamics and eciency. Coasian dynamics (see Hart and Tirole (1988)) mean that higher valuation consumers make their purchase no later than lower valuation consumers (the `skimming property'); and that the equilibrium price of the durable good is nonincreasing over time (the `price monotonicity property'). Coasian eciency ensures that the durable good is priced at marginal cost, and that the market is covered immediately; both factors mean that the present discounted value of consumer surplus is maximised. Network externalities exist when (a) there is a direct physical e ect of the number of users or quantity demanded on the quality of a good; (b) there is an indirect consumption externality, as the number or range of complementary products increases 1

with usage of the good. (See Katz and Shapiro (1985) and Farrell and Saloner (1985) for the seminal papers in a large literature.) Network externalities tend to give rise to concentrated industry structures. When the value of a good increases with the size of the network, consumers have an incentive to join the largest network. In this case, equilibrium can be characterised by a small number of (large) networks. For a given technology, network externalities may limit the number of networks. For example, if consumers expect a network to be dominant, then consumers will be willing to join only the dominant network. In equilibrium, only network operates, and expectations are con rmed. When there is innovation, an installed base can lead to excess inertia with respect to adoption of new technologies; see Farrell and Saloner (1986), amongst others. The e ect again is to limit the number of active rms in equilibrium (in this case to the incumbent network). This tendency to concentration leads Katz and Shapiro (1985) to observe that \network externalities are similar to xed costs in that they can lead to a limited number of active producers" (p. 431). Katz and Shapiro (1986) rst raised the possibility that network externalities might lead to the monopoly price of a durable good increasing over time: \The sponsor's [i.e. rm introducing a new technology to the market] problem is the opposite of the durable good monopolist's problem, as posed by Coase (1972) .... the time consistency problem for the sponsor is that it cannot commit to a second-period price other than the `high' one that will maximise pro ts at the time." (p. 840.) The intuition is straightforward. Network size is equivalent to a parameter of vertical di erentiation: the larger the network, the higher the value of the good to consumers. Therefore, a lower initial price which increases the number of initial users raises the value of the good to future consumers; this may allow the monopolist to charge a higher price later. Bensaid and Lesne (1996) provide an explicit analysis of this possibility in a discrete time model. They show, for network externalities of a certain type and sucient size, that the equilibrium price rises over time, and lies everywhere above marginal cost i.e. both the dynamic and eciency features of the Coase conjecture are overturned. 2

This paper develops a model of production of a durable good in the presence of network externalities. It asks: what is the subgame perfect (i.e. strong Markov perfect) equilibrium of the model when producers have an in nitesimal period of commitment? The use of a discrete time model (as in e.g. Bensaid and Lesne (1996)) implicitly allows the monopolist a period of commitment. Stokey (1981) makes clear that this is a crucial assumption. The continuous time framework used here means that the implicit commitment period is zero.1 Two results are presented. First, when the good is in nitely durable, the Coase conjecture may fail in its strongest form when network externalities are present. For a broad class of network bene t functions (those that are increasing over some range of the network size), the Markov perfect equilibrium is the same for monopolistic and perfect competitive market structures. Socially optimal pricing (price equal to marginal cost) prevails in both cases. But the time-consistent producers grow the network more slowly than is socially optimal. Secondly, a committed monopolist may be socially preferable to a time consistent producer when network externalities are suciently large. The former grows the network at the socially optimal rate, but restricts the long-run size of the network. The latter grows the network too slowly, but attains the socially ecient network size in the long-run. These results indicate that the model of network externalities can be viewed as a demand-side counterpart of Olsen's (1992) learning-by-doing model. The rest of the paper is structured as follows. The next section analyses sales of an in nitely durable good when network externalities are present. A general network function is used; section 3 deals with speci c examples. Section 4 concludes. The appendix contains details of the model. Xie and Sirbu (1995) also analyse a continuous time model of durable good sales; but they allow commitment on the part of the monopolist, who chooses open-loop rather than feedback strategies. The continuous time formulation also simpli es the analysis by eliminating non-linear terms which are present in a discrete time model. The continuous time model should be seen, however, as the limiting case of a discrete time analysis as the period of commitment tends to zero. Thus attention is restricted to equilibria of the continuous time model that have the same characteristics as the equilibrium of the discrete time model. 1

3

2. Network Externalities and an Infinitely Durable Good

The model is based on Stokey (1981) and Karp (1993, 1996a,b). A monopolist chooses output to maximise the present value of a discounted stream of pro ts from production of a durable good. There is no depreciation of the good; there are no capacity constraints; the monopolist must sell, rather than rent its output; and the monopolist uses an in nite time horizon. There is a continuum of non-atomic, in nitely-lived consumers, each with a demand for one unit of the durable good. They do not consider the e ect of their decisions on others,2 and hold rational expectations about the monopolist's production plans. Players (the producer and the consumers) use stationary Markovian strategies. The notation is as follows: output at time is ( ); the stock of the durable good (the state variable) is ( ); the selling price is ( ); constant unit production costs are ; and the common discount rate is . There is common knowledge of all aspects of the model. t

q t

Q t

P :

c

r

2.1. The Price Function

Utility from purchasing the good has two components. The rst is intrinsic, derived from the ow of services from the good itself; this is denoted . It is assumed throughout the paper that consumers' intrinsic valuations are uniformly distributed on the interval [ 1]. In addition, there is a network e ect, so that the gross surplus derived by a consumer with intrinsic valuation buying at time is b

b;

b

vt

=

b

+

t

(1)

knt

where t is the size of the network externality at time and  0 is a scaling parameter. The following general assumptions are made about the network function ( ) (speci c examples are given in the next section): (i) it is non-negative: t  0 8 ; (ii) it is Markovian and stationary: t  ( ( )); (iii) it is piecewise continuous; and (iv) there exists at least one value b such that 1 , b + ( b ) = . Assumption n

t

k

n :

n

n

t

n Q t

Q

Q

kn Q

c

To be precise: a unilateral deviation by a consumer from its equilibrium strategy does not change the actions of other consumers or the monopolist. 2

4

(i) con nes attention to positive network externalities. The Markovian assumption in part (ii) is less restrictive than it appears. Consumers' expectations of future output are assumed to depend only on the current level of the durable good stock i.e. e( + ) = Q( ( ) ) for some continuously di erentiable function Q( ) (where e ( ) denotes the stock of the good expected at time ). It is assumed further that consumers' expectations are ful lled in equilibrium: e( ) = ( ) 8 . Consequently, although network bene ts may depend on future sizes of the network, they can be written as a function of the current network size. A stronger assumption is that the network function is stationary; this is commented on further in section 2.3. Assumption (iii) ensures (local) existence of a solution to the problem that is analysed; assumption (iv) ensures that a steady state exists. Q

Q

t

s

Q t ;s

:

s

s

Q

s

Q s

s

Finally, the following parametric restrictions are made: (i) 0 ( ) 1 8 ; and (ii) + (1 , )  . Part (i) ensures that the inverse demand function for the services of the good is downward sloping (see below); it requires to be suciently small, and means that the `skimming property' holds in this model { high valuation consumers buy rst. The size of the network in period is therefore kn

kn

b

b

Q

<

Q

c

k

t

( ) = 1,

Q t

bt ;

where t is the intrinsic valuation of the marginal consumer who is indi erent about buying at time . Part (ii) means that price eventually is driven to marginal cost and the market covered. In other words, this paper examines only the `no gap' case identi ed by Gul et al. (1986). This is, arguably, the more realistic case to consider. Section 2.3 considers the `gap' case. b

t

The rental price

Ft

in period is therefore t

( ( )) = 1 , ( ) + ( ( ))

F Q t

Q t

kn Q t

(2)

:

The selling price ( ) at time is given by the relationship P :

t

() =

P :

Z1 e,r(s,t) F (Qe(s))ds:

(3)

t

The assumptions on consumers' expectations mean that ( ) = ( ( )), and that the P :

5

P Q t

price function is continuous and almost everywhere di erentiable. When the stock of the durable good changes continuously, equation (3) can be di erentiated with respect to time3 to give ( ( )) =

dP Q t dt

( ( )) , ( ( )) +

rP Q t

F Q t

k

( ( ))

dn Q t dt

:

(4)

The economic intuition for equation (4) can be understood by supposing that there is a perfectly functioning second-hand market for the durable good. The equality states that the marginal consumer should be indi erent between borrowing to buy the good, deriving an instantaneous utility, and reselling to pay o the loan. Therefore, utility should equal the interest payment on the loan minus the price capital gain dPdt plus the `network capital gain', dn dt . If this last term is positive, then the consumer has an added incentive (relative to the no network externality case) to delay purchase until the network is larger. When the stock changes by a discrete amount (from 1 to 2 , say), then continuity requires that ( 1) = ( 2). F

rP

k

Q

Q

P Q

P Q

2.2. The Markov Perfect Equilibrium

This section derives the strong Markov perfect equilibrium for the model. Taking the price function as given, the monopolist's problem is Z1

max e,r(s,t) ( ) [ ( ) , ] q(s)0 t ( ) st = ( ); (0) given q s

: :

dQ t dt

q t

P Q

Q

c ds

(5)

:

The solution to problem (5) and the function ( ) generate a price path which in equilibrium satis es equation (4). The monopolist cannot commit to a production path, but must choose a stationary Markovian decision rule for output. The necessary condition for pro t maximisation is given by the Bellman equation P Q

rJ

= max q0

"

( ), +

P Q

c

@J @Q

# q:

(6)

The di erential equation for price can be checked by taking the limit of a discrete time model, to ensure that all relevant terms are included. This task is performed in the appendix. 3

6

is a solution to the Bellman equation; it is veri ed below that it is di erentiable in (as assumed in equation (6)), and that it is also a value function of the problem (5). The problem is linear in the control , and so the optimal solution may involve discontinuities in output. ( ) is therefore restricted to be a piecewise continuous function of time. J

Q

q

q :

Let ( b ) = . Consider any interval in [ 0 b ) over which output is non-zero and nite. The linearity of the Bellman equation means that the singular solution F Q

rc

Q ;Q

( ), +

P Q

c

@J @Q

= 0

(7)

must hold over this interval. Therefore = 0; and hence Consumer rationality (i.e. equation (4)) then requires J

0 =

rc

, ( )+ F Q

kn

@J @Q

= 0 and ( ) = . P Q

c

0 (Q)q:

(8)

If 0 ( ) = 0 on this interval, then equation (8) implies that ( ) = i.e. = b (a constant). This is inconsistent with 0 over this interval. If 0( ) 0, then equation (8) implies that = Fkn(Q0)(,Qrc) . Since output must be non-negative, this requires that  b . This is inconsistent with a stable steady state (with = b ). Therefore, output can be non-zero and nite only when 0( ) 0. kn

Q

F Q

q >

rc

kn

Q

Q

Q

<

q

Q

Q

Q

kn

Q

Q

>

Consider now an interval in [ 0 b ] over which = 0. Clearly, the stock is constant during such an interval; and, due to stationarity, so is the price ( ). b, ( ) , and the timeTherefore ( ) = F (rQ) , from equation (4). If consistent monopolist sets output above zero. Therefore = 0 is consistent with equilibrium only when = b and ( ) = . Q ;Q

q

Q

P Q

Q < Q

P Q

P Q

> c

q

Q

Q

P Q

c

Finally, consider an interval in [ 0 b ) over which is in nite, producing a discrete change in the durable good stock. Since the problem is linear in the control, the principle of the Most Rapid Approach Path applies (see Clark (1990)). The stock is increased to the start of a singular interval, or to the steady state if the former does not exist. In either case, price equals cost after the jump in the stock; and, by consumer rationality (continuity of the price function), therefore equals cost before the jump. Q ;Q

q

7

The preceding argument shows that the Markov perfect equilibrium is as follows: ( ) = = Fkn(Q0)(,Qrc) = 1 = 0

P Q q

c;

;

;

0 (Q) 0 kn (Q) kn

0  0 >

;

b

;

Q

<

Q;

;

Q

<

Q;

Q

=

Q:

(9)

b b

In equilibrium, the monopolist prices at marginal cost and earns zero pro ts (as predicted by the Coase conjecture). Over any interval in [ 0 b ) where 0 ( ) 0, the rate of production is non-zero and nite. Production continues until the stock of the durable good reaches the steady state level of b , which is determined by the Q intersection of the network function ( ) with the line c,1+ k ; this is illustrated in gure 1 for the case when 0 0 8 2 [ 0 b ]. The time to reach the steady state may be greater than zero, and may even be in nite (depending on the form of ( )).4 Q ;Q

kn

Q

>

Q

n Q

kn >

Q

Q ;Q

n :

Consider next production of the durable good by a perfectly competitive industry. Economides and Himmelberg (1995) and Economides (1996) use a static model to argue that a monopolist who is unable to price-discriminate will support a smaller network and charge higher prices than perfectly competitive rms; and thus that consumer and total surplus will be lower in monopoly than in perfect competition. The dynamic model in this paper shows that the perfectly competitive industry (producing compatible goods) prices at marginal cost. At the same time, the competitive price path must satisfy equation (4). The competitive equilibrium is therefore precisely the same as the monopolistic (Markov perfect) equilibrium: in both, price is This is the unique equilibrium. Consider an alternative equilibrium in which the price function is = c + (Q), with  0. The time-consistent monopolist will always choose a positive production rate whenever price is above cost. If a nite rate is chosen, then the Bellman equation requires @J = 0 i.e. J = 0. But the value function cannot be zero when there is positive that P , c + @Q output with price above cost. Hence the monopolist chooses an in nite rate of production when price is above cost, causing a discrete change in the stock of the durable good. The change is such that, after the jump, price equals cost. But rational consumers anticipate this jump, and require that the equilibrium price just before the discrete change be equal to the price immediately after. Consequently, price cannot be above cost over any interval of Q. It is then immediate that there is no equilibrium with price below cost. Note also that, in this equilibrium, both price and the stock of the durable good converge to a steady state; hence the solution J to the Bellman equation is a value function of the maximisation problem (5). Since J (Q) = 0, it is a di erentiable function of Q. 4

P

8

Q,(1,c) k

1,c 1,k

( )

n Q

45 ,(1,c)

1,

b 1,c

c

Q

1,k

Q

k

Figure 1: The Steady State in the Markov Perfect Equilibrium: 0

n >

0

set at marginal cost and production occurs according to equation (9). Finally, consider socially optimal production of the durable good. The Bellman equation for the social planner is rV

( ) = max q0 Q

"

( )

F Q r

, + c

@V @Q

# q

where ( ) is the planner's value function. For a non-zero but nite production rate to be optimal, there must be an interval over which V

Q

( ), +

F Q r

= 0

@V

c

(10)

:

@Q

During such an interval, ( ) = 0 and F (rQ) = . But the latter equality implies that 0 ( ) = 0; since 0 ( ) 0, must equal zero. The singular interval is, therefore, the point = b . The linearity of the problem means that it is optimal to adjust the stock of the durable good instantaneously to the steady state level b at the start of the planning period. The social surplus from production is V

qF

Q

F

Q

Q

Q

<

c

q

Q

Q

Z Qb Q0

( )

F Q r

dQ

, ( b , 0) c Q

Q

:

Comparison of the programs of the time-consistent producers and the social planner gives the following proposition: 9

Proposition 1: The Markov perfect equilibria of monopolistic and perfectly com-

petitive industries are identical. In both, price equals the socially optimal level of marginal cost. If kn0 (Q) > 0 over any interval in [Q0 ; Qb ), then monopoly and perfect competition exhibit delay: the network grows too slowly compared to the social optimum.

Proposition 1 shows that there is no loss in welfare due to market power; nevertheless, the strong form of the Coase conjecture fails when network bene ts are increasing in the current network size (over some interval). The monopolist prices eciently, but covers the market more slowly than is socially optimal. The intuition for the pricing part of the result is straightforward. The last consumer to buy has a total valuation equal to the marginal cost of production. Consumers anticipate, therefore, that price will equal cost in the long-run. Since the marginal cost is constant, price drops immediately to this level in the continuous time model. The network growth result is more surprising; the intuition is clearest using Coase's original insight that the time consistent monopolist is equivalent to a sequence of monopolists. Each rm in the sequence does not gain the full bene t an increase in the current size of the network, since future rms will act against its interest. This externality means that each rm sells too little, relative to the socially optimal policy.5 Two points are worth noting about the proposition. First, failure of the strong Coase conjecture occurs with a broad class of network bene t functions. All that is required for ineciency is the function to be increasing over some interval. It is possible, of course, for the function to be at or downward sloping over some range; this will be the case when e.g. the network is subject to congestion. (An example of this is discussed below.) But it seems reasonable to suppose that the function will have some upward-sloping portion, however small. Secondly, the result is similar to those that emerge from learning-by-doing models in which marginal costs Given that the monopolist is indi erent between any production plan in which price equals cost, why does it not therefore follow the socially optimal plan and cover the market immediately? Recall footnote 1: attention is restricted to equilibria of the continuous time model that have the same characteristics as the equilibrium of the discrete time model. In the latter, it is clear that the monopolist sells too slowly and receives a price above cost. The continuous time analysis shows that the limit of the discrete time solution, as the interval between periods goes to zero, also involves delay in network growth, but has price equal to cost. 5

10

decrease with cumulative production. For example, Olsen (1992) nds that a durable good monopolist produces more slowly than is socially optimal; and that the timeconsistent monopoly and perfect competition equilibria are identical. The intuition is the same: each rm in the sequence which makes up the time-consistent monopolist does not bene t fully from reductions in current costs, and so produces too slowly. Here, a similar e ect is at work, but on the demand, rather than supply, side. 2.3. Extensions

This section deals with three possible extensions to the model: (i) a non-stationary network function; (ii) the `gap' case; (iii) a bargaining interpretation. The network function ( ) has been taken to be Markovian and stationary. The rst assumption is reasonable when expectations are Markovian. The requirement of stationarity rules out network functions of e.g. the following form: n :

n

=

Z1 e,r(s,t) Qe (s)ds; t

where e( ) is the expected stock at time and is therefore a function of ( ) and , . This function explicitly includes the ow of network bene ts from the time that the good is bought. It is non-stationary:  ( ( ) ), and therefore so is a buyer's total valuation (intrinsic plus network bene t). Ausubel and Deneckere (1989) show that non-stationarity (of preferences and strategies) leads to a folk theorem: there is a continuum of subgame perfect reputational equilibria with monopoly pro ts ranging from zero to the open-loop, full commitment level. There is little to be gained from simply repeating this result in a model with network externalities { hence the focus on the stationary case. Q

s

s

s > t

Q t

t

n

n Q t ;t

The analysis assumes that the total valuation (intrinsic plus network term) of the consumer with the lowest valuation is below the marginal cost of production of the durable good. Gul et al. (1986) showed that there is a signi cant di erence between this `no gap' case, and the case where the lowest valuation is greater than

11

cost (the `gap' case).6 The `gap' case can be modelled here by supposing that the rental function is ( ) = (1 , + ( )) for 2 [0 ] and ( ) for , b . Proposition 1 must be modi ed in the obvious way for the `gap' case. where The strong form of the Coase conjecture still fails. The Markov perfect equilibrium involves price at time equal to the lowest valuation at time ; the network reaches its long-run size in nite, but non-zero time if 0( ) 0 over some interval of 2 [0 ]. The social optimum requires that the network grow immediately to , and price equal (1 , + ( )). F Q

r

Q

kn Q

Q

;Q

F Q

< rc

Q > Q

Q < Q

t

t

n

Q

Q

;Q

Q

>

Q

Q

kn Q

Finally, in the absence of network externalities, a model of sales of a durable good is formally equivalent to a model of bargaining with o ers made by the uninformed party; see Gul et al. (1986). Is there a similar bargaining interpretation when network externalities are present? The interpretation requires that the informed party revise upward its valuation of the good (conditional on not having accepted an o er already) each time the uninformed party makes a new o er (e.g. because each o er conveys information about the true worth of the good being traded). The analysis of this paper suggests that delay should occur in such a bargaining situation, even when the time between o ers goes to zero. 3. Two Examples

This section presents two examples of network functions. The examples are not chosen particularly for realism (although stories can be told to support the functional forms). Instead, their purpose is to illustrate the main features of the model, and to make welfare comparison of alternative equilibria tractable.

Gul et al. (1986) showed that there is a continuum of subgame perfect equilibria in the `no gap' case, while in the 'gap' case, there is a unique subgame perfect equilibrium. They also show that the multiplicity of equilibria in the `no gap' case is eliminated when a regularity condition is placed on consumers' strategies. This paper has required that consumers' expectations are continuous (i.e. that the price function in equation (3) is continuous); this satis es Gul et al.'s regularity condition, and so equilibrium multiplicity is not a consideration here. 6

12

Example 1: n(Q) = Q.

In the rst example, the network function is linear in the current state. One interpretation for this form is that current consumers do not bene t from future increases in the network size. (For example, the rst buyers of software do not bene t from the externalities that they generate { e.g. discovering software bugs { unless they purchase future updates.)7 This is the continuous time version of the `excluded' network externality function used by Bensaid and Lesne (1996). They argue, using a discrete time model, that the monopolist prices above marginal cost at all times; and (if is suciently large) price may rise over time and the monopolist's pro ts are una ected by its inability to commit to a production plan. Their results therefore contradict both the dynamic and eciency features of the Coase conjecture. In contrast, the continuous time model in this paper shows that price is equal to cost, with production given by k

q

=

r

(1 , ) , (1 , ) c

r

k

k

The steady state durable good stock is 2, which sets 0 = 0) are

k

b

Q

Q:

= 11,,kc . The dynamics (illustrated in gure

Q

() =

Q t

() =

q t

r



r (1,k)

r (1,k)

0 e, k t + b 1 , e, k (1 , )  b ,  e, r k,k t 0

Q

k

k

Q

(1

Q

Q

t

 ;

)

:

The steady state is not reached in nite time. The simple case of a linear network function allows a direct comparison of social welfare in the di erent equilibria. The time consistent monopolist (who is unable to commit) is socially inecient, since it causes the network to grow too slowly; but it does not restrict the long-run size of the network. The `committed' monopolist is socially inecient, not because it sells too slowly, but because it sets the long-run network size too low. Which monopolist is socially preferable (causes the smaller loss 7

In this example, the assumptions on n(Q) and the model parameters require: (i)

k b  1c, ,k .

13

k <

1; (ii)

()

()

q t

Q t

1,c 1,k r(1,c) k

t

t

Figure 2: Dynamics for the time consistent monopolist in example 1 in social welfare) depends on, amongst other things, the size of the network externality parameter . When is close to, but greater than, zero, then the time consistent monopolist causes little delay.8 For larger , however, the Markov perfect equilibrium involves considerable delay; the welfare loss of this delay may be greater than the loss due to output restriction by the committed monopolist. The welfare comparison is clearest when the initial stock of the durable good 0 is zero. k

k

k

Q

Proposition 2: In example 1 with Q0 = 0, social welfare is higher (lower) when the

monopolist is unable to commit, relative to the commitment case, when k < (>) 0:4. Proof: Social welfare from the time consistent monopolist's production path is V

2 ((1 , ) , (1 , )) 0 MPE = 2, k Q

c

k

:

Stokey (1979) shows that the `committed' monopolist solves the static pro t maximIt is straightforward to verify that the time taken to reach any given stock level is monotonically increasing in k. 8

14

isation problem: max Q0

Q

( ),

F Q r

! c

:

The sucient rst-order condition ( ) + 0( ) = gives a pro t maximising stock of y = 2(11,,ck) . (The committed monopolist jumps instantaneously to this stock at = 0, and then ceases production.) Social welfare from this program is F Q

QF

Q

rc

Q

t

2 (1 , )2 ((1 , ) , (1 , )) 0 , 8(1 , ) OLE = 2(1 , ) k Q

V

c

k

c

k

:

When 0 = 0, Q

(1 , c)2(2 , 5k) MPE , VOLE = 8(2 , k)(1 , k) :

V

Since

k <

1, MPE V

OLE if k < 0:4 (and vice versa).

> V

2

The parameter-dependent welfare comparison of proposition 2 should be contrasted with the learning-by-doing result of Olsen (1992), that the committed monopolist is always less ecient than the time-consistent producer. Example 2: n(Q) = Qb .

In the second example, network bene ts depend only on the nal (steady state) size of the network. This example is best viewed as an approximation to a network function which is very steeply sloped at low network sizes, reaching a plateau quickly. Access to the internet for web sur ng may be one such case. The indirect externalities (e.g. more and better designed web sites to visit) which arose as more people joined the internet were rapidly balanced by the concomitant congestion. The end result may be a network bene t for web sur ng which is roughly constant over a broad range of network sizes. In this case, the monopolist sets initial production to adjust the stock of the durable good instantaneously to the level b ; as in example 1, price is equal to cost, and monopoly pro ts are zero. The Coase conjecture holds in its strongest form. The result can be understood by applying again Coase's intuition. When network externalQ

15

ities take this form, then each rm in the sequence that comprises the time-consistent monopolist, while still interested only in maximising its own pro ts, necessarily considers the long-run consequences of its pricing decision. The intertemporal externality between rms disappears, and the time-consistent monopolist (and perfectly competitive industry) replicates the socially optimal outcome. 4. Conclusions

This paper has examined the production of a durable good in the presence of network externalities in order to address two questions. First, what is the e ect of market structure on network size in a dynamic model with rational expectations? Secondly, is the intuition that network externalities are `economies of scale on the demand side' correct? It has been shown that there are circumstances in which network externalities cause the strong form of the Coase conjecture to fail. In this model, market structure makes no di erence to the price (which is set at the socially optimal level of marginal cost) or production in the Markov perfect equilibrium. When network bene ts are increasing in the network size over some interval, however, both industries grow the network too slowly compared to the social optimum. This leads to the possibility that it may be socially preferable to allow a monopolist the ability to commit (e.g. by renting rather than selling the durable good). The analysis suggests an analogy between network externalities and learning-bydoing. The key is that there is an intertemporal externality in both situations: each rm in the sequence which makes up the time-consistent monopolist does not consider the welfare of future versions of himself when making its current decision. With network externalities, this leads to delay in network growth; with learning-by-doing, costs decrease too slowly. This provides further support for the intuition that network externalities can be viewed as `economies of scale on the demand side'.

16

APPENDIX

In order to determine the time derivative of equation (3) when network externalities are present, the model is written rst in discrete time (as in e.g. Gul et al. (1986)); reducing the time between periods to zero then gives the correct continuous time expression. The monopolist speci es a price Pt to charge in each period. Consumers' strategies are to accept or reject the o ered price (conditional on not having accepted already). The monopolist and consumers use stationary Markovian strategies i.e. their decisions are functions only of the current stock of the durable good. The indi erence condition of the marginal consumer in period t is bt

+ knt , Pt =  (bt + knt+ , Pt+ ) :

(A1)

 is the length of each period in real time. The per-period discount rate is  = e,r , where r is the continuous time discount rate. nt is the size of the network externality in period t. Rearranging equation (A1) gives: bt

+ knt , 1 k ,  (nt+ , nt) =

Pt

, 1 ,  (Pt+ , Pt ) :

Now replace  with e,r , and use the approximation e,r  1 , r for small :   (1 , r ) nt+ , nt bt + knt , = r  k

  1 , r  Pt+ , Pt Pt , : r 

Taking the limit as  ! 0 gives dPt dt

=

rPt



rPt

t , r(bt + knt ) + k dn dt t , Ft + k dn ; dt

where the second line follows because, when  = 0, the rental rate can be written as Ft

 r (bt + knt ) :

(Note that, due to the assumption of a uniform distribution, Qt = 1 , bt .)

17

(A2)

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Katz, M. L. and C. Shapiro, (1985): \Network Externalities, Competition, and

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19

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