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Compatibility and Market Structure for Network Goods


  • Nicholas Economides
  • Fredrick Flyer


This paper analyzes the economics of industries where network externalities are significant. In such industries, firms have strong incentives to adhere to common technical compatibility standards, so that they reap the network externalities of the whole group. However, a firm also benefits from producing an incompatible product thereby increasing its horizontal product differentiation. We show how competition balances these opposing incentives. We find that market equilibria often exhibit extreme disparities in sales, output prices, and profits across firms, despite no inherent differences in the firms' production technologies. This may explain the frequent domination of network industries by one or two firms. We also find that the presence of network externalities dramatically affects conventional welfare analysis, as total surplus in markets where these externalities are strong is highest under monopoly and declines with entry of additional firms.

Suggested Citation

  • Nicholas Economides & Fredrick Flyer, 1997. "Compatibility and Market Structure for Network Goods," Working Papers 98-02, New York University, Leonard N. Stern School of Business, Department of Economics.
  • Handle: RePEc:ste:nystbu:98-02

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    References listed on IDEAS

    1. Nicholas Economides, 1997. "The Economics of Networks," Brazilian Electronic Journal of Economics, Department of Economics, Universidade Federal de Pernambuco, vol. 1(0), December.
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    6. Donsimoni, Marie-Paule & Economides, Nicholas S & Polemarchakis, Herakles M, 1986. "Stable Cartels," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 27(2), pages 317-327, June.
    7. Jaskold Gabszewicz, J. & Thisse, J. -F., 1979. "Price competition, quality and income disparities," Journal of Economic Theory, Elsevier, vol. 20(3), pages 340-359, June.
    8. Katz, Michael L & Shapiro, Carl, 1985. "Network Externalities, Competition, and Compatibility," American Economic Review, American Economic Association, vol. 75(3), pages 424-440, June.
    9. Nicholas Economides & Charles Himmelberg, 1995. "Critical Mass and Network Size with Application to the US Fax Market," Working Papers 95-11, New York University, Leonard N. Stern School of Business, Department of Economics.
    10. Raymond Deneckere & Carl Davidson, 1985. "Incentives to Form Coalitions with Bertrand Competition," RAND Journal of Economics, The RAND Corporation, vol. 16(4), pages 473-486, Winter.
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    Cited by:

    1. repec:wsi:ijitmx:v:08:y:2011:i:04:n:s0219877011002581 is not listed on IDEAS
    2. Fabio Manenti & Ernesto Somma, 2008. "One-Way Compatibility, Two-Way Compatibility and Entry in Network Industries," International Journal of the Economics of Business, Taylor & Francis Journals, vol. 15(3), pages 301-322.
    3. Clements, Matthew T., 2004. "Direct and indirect network effects: are they equivalent?," International Journal of Industrial Organization, Elsevier, vol. 22(5), pages 633-645, May.
    4. Jiawei Chen & Ulrich Doraszelski & Joseph E. Harrington, Jr., 2009. "Avoiding market dominance: product compatibility in markets with network effects," RAND Journal of Economics, RAND Corporation, vol. 40(3), pages 455-485.
    5. Baake, Pio & Boom, Anette, 2001. "Vertical product differentiation, network externalities, and compatibility decisions," International Journal of Industrial Organization, Elsevier, vol. 19(1-2), pages 267-284, January.
    6. Sam Chandan & Christiaan Hogendorn, 2001. "The Bucket Brigade Pricing And Network Externalities In Peer-To-Peer Communications Networks," Wesleyan Economics Working Papers 2001-001, Wesleyan University, Department of Economics.
    7. Guibourg, Gabriela, 2001. "Interoperability and Network Externalities in Electronic Payments," Working Paper Series 126, Sveriges Riksbank (Central Bank of Sweden).
    8. Baohong Sun & Jinhong Xie & H. Henry Cao, 2004. "Product Strategy for Innovators in Markets with Network Effects," Marketing Science, INFORMS, vol. 23(2), pages 243-254, October.
    9. Christian Wey, 1999. "Compatibility Investments in Duopoly with Demand Side Spillovers under Different Degrees of Cooperation," CIG Working Papers FS IV 99-02, Wissenschaftszentrum Berlin (WZB), Research Unit: Competition and Innovation (CIG), revised Aug 1999.
    10. Roy Jones & Haim Mendelson, 2011. "Information Goods vs. Industrial Goods: Cost Structure and Competition," Management Science, INFORMS, vol. 57(1), pages 164-176, January.
    11. Matthew Mitchell & Andrzej Skrzypacz, 2006. "Network externalities and long-run market shares," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 29(3), pages 621-648, November.

    More about this item


    networks; network externalities; coalition structures; technical standards; compatibility;

    JEL classification:

    • L1 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance
    • D4 - Microeconomics - - Market Structure, Pricing, and Design


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