Trade negotiations in the presence of network externalities

Network externalities exist when the benefit a consumer derives from a good or service depends on the number of other consumers using the same good, or service (as happens, for example, with telecommunications, television broadcasting standards, and many other technology-related goods and services). National monopolies, regulated and endorsed by sovereign governments, tended to produce network externalities in the past: most countries had telephone monopolies, often state-owned, before deregulation. Whether to allow foreign competition in such industries becomes a pressing issue when national boundaries begin to blur as technology advances, and as previously untraded goods and services become tradable. Despite obvious gains from trade in such newly tradable sectors, governments often keep trade-prohibiting measures. With analog high definition television (HDTV) transmission standards, for example, regulations and politics kept Europe, and Japan from cooperating, so each invested heavily to develop its system in an attempt to have its own standard adopted by the rest of the world. The author analyzes how the presence of network externalities affects a country's willingness to trade. In her model, governments decide whether or not to allow international trade. When trading is permitted, the superior standard drives out all other in the trading area. She shows that even when there are efficiency gains from worldwide standardization, global free trade may not prevail. The technology leader is generally eager to trade, but countries with less advanced technology often choose to form inefficient regional blocks, or not to trade at all. Once such regional networks are established, global efficiency-enhancing free trade becomes even harder to achieve than it would have been in their absence. Transfer payments between countries reduce or eliminate such inefficiency, and facilitate the achievement of efficient trade in products. To achieve mutually beneficial arrangements, it is important to arrive at multilateral agreements before regional blocks form.