Network Industries - New York University

Network Industries - New York University

Business of Social and Other Networks Presentation Prof. Nicholas Economides Stern School of Business, New York University http://www.stern.nyu.edu/networks/ Haas School of Business, UC Berkeley and NET Institute http://www.NETinst.org/ mailto:[email protected] April 29, 2015 Copyright Week 1: Introduction Requirements Midterm exam Class participation; interactivity

Final group project Groups of 3 writing an original paper Preliminary presentation of paper on week 10 Subject matter Areas we will cover 2 Overview: Areas we will cover Week 1-2, pp. 16-47 (all approx.) Summary of basic economics of competition in non-network industries Basic Game Theory

3 Overview: Areas we will cover Week 2, pp. 48-75 Nature and types of networks Various types of networks including virtual networks Features Network creation/expansion Superimposition of various networks 4

Overview: Areas we will cover Week 3, pp. 76-85 Internet basics Infrastructure Basic Protocols Pricing Search algorithms and advertising Organic search; paid search Week 4, pp. 86-102

Cybersecurity and privacy 5 Overview: Areas we will cover Week 4: pp. 103-114 Network structures and platforms Two-sided pricing 6 Overview: Areas we will cover Week 5, pp. 115-140 Network structures and platforms

Network properties Network effects Platforms Pricing on networks Nature of competition on networks 7 Overview: Areas we will cover Weeks 6-7, pp. 141-164 Compatibility and interconnection

Desirability Divergence of private and public incentives Public policy issues 8 Overview: Areas we will cover Week 7, pp. 165-179 Bottlenecks and Interconnection Pricing 9 Overview: Areas we will cover Week 8, pp. 180-184 Taxi cabs as a two-sided network

Electric cars as a two-sided network 10 Overview: Areas we will cover Week 9, pp. 185-220 Payment Systems (credit and debit cards) Mobile Money 11 Overview: Areas we will cover

Weeks 10, pp. 221-237 Digital Books Week 11, pp. 238-279 Two-sided Pricing & Network Neutrality Network neutrality on the Internet 12 Overview: Areas we will cover Weeks 12 Bottom line, pp. 280-304 Additional materials Antitrust in Networks Industries, pp. 305-329

Bank networks formation and systemic risk, pp. 330-336 13 References

Chris Anderson, The Long Tail, Hyperion, New York, 2006. John Battelle, The Search, Penguin, New York, 2005. Brock, Gerald, The Telecommunications Industry: The Dynamics of Market Structure, Harvard University Press, 1981. Carlton, Dennis, and Jeff Perloff, Modern Industrial Organization, Harper Collins. Crandall, Robert, After the Breakup: US Telecommunications in a More Competitive Era, The Brookings Institute, Washington, D.C., 1991. David Easley and Jon Kleinberg, Networks, Crowds, and Markets: Reasoning About a Highly Connected World, Cambridge University Press, 2010 Laffont, Jean-Jacques, and Jean Tirole, Competition in Telecommunications, MIT Press, 2002. Mitchell, Bridger M., and Ingo Vogelsang, Telecommunications Pricing: Theory and Practice. Cambridge University Press, 1991. Owen, Bruce, and Steve Wildman, Video Economics, Harvard University Press, 1992. Shapiro, Carl, and Hal Varian, Information Rules, Harvard Business School Press, 1999. Specific references in each module below. 14

Network industries are a large part of the world economy and some are growing very fast Telecommunications (data, voice) Internet / world wide web

Social networks on the Internet (Facebook, Twitter, etc.) Broadcasting (TV, radio) Cable television Financial networks Credit and debit card networks ATMs, bank networks; payment systems; check clearing houses Financial exchanges (equities, bonds, derivatives) Banking networks and systemic risk B2B, B2C exchanges Electricity Railroads Airlines Roads Virtual networks Computer software and hardware

Information servers (yellow pages, Google, Yahoo, MSN) 15 A virtual network is a collection of compatible goods/components that share a common technical platform. For example, all VHS video players make up a virtual network. Similarly, all computers running Windows can be thought of as a virtual network. Compatible computer software and hardware make

up a network, and so do computer operating systems and compatible applications. More generally, virtual networks are composed of complementary components, so they also encompass wholesale and retail networks, as well as information networks and servers such as telephone yellow pages, Yahoo, Google, etc. 16 Network industries often provide necessities provide infrastructure are key to economic growth Network industries have special features

17 Is competition different in these industries? What are successful strategies for companies in markets and industries with network effects? Is there a special case for or against antitrust or competition policy scrutiny for network industries? What form should intervention take (if any)?

Price controls? Subsidies? Structural changes (breakups, divestitures, etc.) 18 Weeks 1-2: Summary of Basic Competition Concepts Supply and demand Definitions

Costs Consumer surplus (CS) Producer surplus (PS) Total surplus (TS) For more extensive discussion, see Pindyck and Rubinfeld, Microeconomics 19 Demand, supply, and price determination 20 Cost definitions

Total costs: C(q). Variable costs: V(q). Fixed costs:F, constant. Breakdown of total costs C(q) = F + V(q). Average total cost: ATC(q) = C(q)/q. Average variable cost: AVC(q) = V(q)/q. Average fixed cost: AFC(q) = F/q. Breakdown of average costs ATC(q) = F/q + AVC(q). Incremental (marginal) cost: MC(q) = C'(q) = dC/dq = V'(q) = dV/dq. 21 Three cost technologies: (1) Constant Returns to

Scale 22 Increasing Returns to Scale, F > 0, MC constant 23 Cost technologies: (3) Increasing and Then Decreasing Returns to Scale 24 Consumers surplus

CS = Total willingness to pay for q units minus consumers expenditure = Area under demand up to q units minus consumers expenditure = A(q) E(q) E(q) = pq when all units are sold at the same price q, but companies sell in many other pricing schemes Keep in mind that in network industries, the CS calculation will be different 25 26 Producers surplus PS = Revenue up to q units minus variable costs = Revenue minus area under marginal cost curve =

pq V Note that Variable Cost V(q) is the area under Marginal Cost MC(q) 27 28 Total surplus TS(q) = CS(q) +PS(q) = A(q) E(q) + E(q) V(q) = A(q) V(q) = net contribution to society of a market for q units (excluding fixed costs) We judge markets according to contribution to TS

TS is maximized at qc. Difference TS(q)-TS(qc) = dead weight loss = loss to society from less or more production than qc. Example of less production than qc: monopoly Example of more production than qc: subsidy 29 30 Total surplus is maximized at qc Keep in mind that this will NOT be true in network industries 31 Price discrimination: ways to reduce consumer surplus and increase profits

Sell different units of the same good to the same buyer at different prices Sell different units of the same good to different buyers at different prices Tying: good A not sold without good B Mixed bundling: selling collections of goods at lower prices than a-la-carte Apple was not selling Macs without an Apple monitor

Microsoft office bundle vs. a-la-carte Loyalty-requirement contract: Discounts are offered if the buyer commits to buying all or most of his needs from same seller 32 Price discrimination towards the same buyer Selling different units of the same product to the same buyer at different prices Electricity bills: higher marginal price for more units

In other cases, last unit sold at a lower price (quantity discount) Collecting a fixed fee with or without a variable fee Mobile, fixed telecom service bills 33 Price discrimination towards the same buyer Loyalty-requirement contract: Offer a discount on some or all units

only if buyer buys 90% of his needs from you Or offer a discount on some or all units of good A only if the buyer buys 90% of his needs of goods A & B Essentially forces buyer to buy B from dominant firm in A 34 Price discrimination towards the same buyer Problems of requirement contracts What if there is a monopolist in good A but there are rivals in good B that produce superior quality of B? Under the requirement contract, rivals in B are eliminated or marginalized

with significant TS loss 35 Price discrimination towards the same buyer Problems of requirement contracts A multi-unit buyer has some CS left in product A even under monopoly The monopolist seller can extract more CS by requiring that the product be only sold with B 36 Price discrimination across buyers Example: IBM in the 1930s leased tabulating

machines; required buyers to buy IBM cards Card use proportional to machine use Machine use roughly proportional to value to buyer IBM used tying to quantify the value to individual buyer IBM used tying to effectively lease different units of the tabulating machines to different buyers at different prices Often tying and bundling are illegal under antitrust law 37 Market organization

Perfect competition Monopoly Many rivals Market price is equal to incremental cost No need to take rivals into account Single seller Market price significantly exceeds incremental cost No rivals

Oligopoly Few firms Market price above cost but below monopoly Need to take rivals actions into account Use game theory to describe market equilibrium 38 Market concentration

Herfindahl-Hirschman index of concentration HHI = in=1 si2 Range from 1 (monopoly) to 0 (perfect competition At egalitarian equality, all si = 1/n, HHI = 1/n Lawyers multiply in=1 si2 by 10,000 so for them the HHI range is [0, 10000] 39 Market classifications by HHI defined by DOJ and FTC http://www.justice.gov/atr/public/guidelines/hhi.ht ml HHI between 1,500 and 2,500:

moderately concentrated HHI > 2,500: highly concentrated Mergers that increase HHI by more than 200 in highly concentrated markets are presumed likely to enhance market power 40 Game Theory Application to Oligopoly Game in extensive form: N players; decision tree; moves; outcomes; information sets; payoffs 1, 2; Game in normal form: strategies Perfect information, perfect recall

Complete information; Harsanyis analysis of incomplete information 41 Games in extensive form: sequential incumbent-entrant game 42 Games in extensive form: simultaneous games 43 Non-cooperative games

Non-cooperative equilibrium (Nash equilibrium, NE): A pair of strategies (s1*, s2*) such that no player can increase his payoff provided that the rival does not change his strategy Best reply: b1(s2) maximizes 1(s1, s2) Best reply: b2(s1) maximizes 44 Prisoners Dilemma Player 1 Player 2 talk silent

Talk (2, 2) (6, 0) Silent (0, 6) (5, 5) Non-cooperative equilibrium is at (2, 2) even though (5, 5) maximizes total utility Players cannot commit to stay silent Other interpretations: arms race; 45 Prisoners Dilemma as an Oligopoly Game Player 1 Player 2

high Q low Q (2, 2) (6, 0) High Q Low Q (0, 6) (5, 5) Non-cooperative equilibrium is at (2, 2) even though (5, 5) maximizes total utility Players would like to commit to low Q, but this is a violation of antitrust 46 Simultaneous IncumbentEntrant Game Pl. 1 (E)

Enter Pl. 2 (I) high Q low Q (-3, 6) (8, 8) Stay (0, 18) (0, 9) There are Outtwo non-cooperative equilibria at (0, 18) and (8, 8) Notice that pl. 1 wants (8, 8) while pl. 2 wants (0, 18) 47

Battle of the Sexes Coordination Game Player 1 Player 2 ballet boxing Ballet (2, 1) (1, 1) Boxin (0, 0) (1, 2) g Non-cooperative equilibria at (2, 1), (1,1) and (1, 2) Which one will occur? 48

Matching Pennies Zero sum game Player 1 Player 2 heads tails Heads (1, -1) (-1, 1) Tails (-1, 1) (1, -1) There is no non-cooperative equilibrium Could use mixed strategies probability distributions over the pure strategies {H, T} John Nash (1951): there exists a noncooperative equilibrium in mixed strategies for

any matrix game 49 Is cooperation needed? To establish a network link between A and B it needs to be profitable for both A and B 50 Week 2: Networks Basics Easley and Kleinberg. See http://www.stern.nyu.edu/networks /E&K/networks-book-ch01.pdf to -ch24.pdf Sanjeev Goyal, Connections,

Princeton University Press, 2007. Chapter 2 51 Networks are composed of complementary nodes and links The crucial defining feature of networks is the complementarity between the various nodes and links A service delivered over a network requires the use of two or more network components Thus, network components are complementary to each other

52 Example: the Information Superhighway (1994) 53 Network structure Nodes: entities Edges/links: relationships Directed or not Features/colors of nodes Features of links 54

Human connections networks Co-authors Facebook Blog readers Members in organizations political parties professions How important is a specific node Strong and weak ties

Cohesion issues What holds the network together? Activity on networks How does it get affected by the network structure? Is behavior influenced by network nearness? How? 55 Blogs in the 2008 presidential campaign 56 Spread of an epidemic 57 World trade network example from Easley and Kleinberg, Figure 1.8 58

Network structure: Undirected and directed graphs 59 Network structure: Connected components 60 Network structure: Breadth-first search 61 A Simple Social Network With Three Components C C is an isolated node D B and E are

not connected, but there is a path between them. E A and E are connected. A is a node with a high degree of centrality A B A and D are also not connected

and there is no path between them. 62 A Star (Hub & Spoke) Network JFK SEA ORD ATL LAX 63 A Complete Network JFK

SEA ORD ATL LAX 64 Competing Platforms C1 The Ms are multihoming; that is, they belong to both networks (connect to more than one platform). M1 P1 C2 C3

There is no interconnection between the networks C4 M2 M3 M4 P2 M5 C5 P1 and P2 are the platforms (e.g., payment-card networks) The Cs are single homing; that is, they belong to just one network (connect to a

single platform). M6 65 Competing Platforms with Interconnection (e.g., telecom) C1 P1 or P2 may need to pay the other an interconnection P1 fee C2 C6 C7 C8

C3 C9 C4 C5 P2 C5 and C9s conversation is on net. C5 and C6s conversation is off net. C10 C11 Concepts, Goyal pp. 9-24

Neighbors of j are those nodes with direct links to j A network is regular if every node has the same number of links Degree of node j is the number of direct connections of j = number of neighbors of j Degree distribution is a n-long vector of the fraction of nodes with degree k (= 1, , n) Variance of the degree distribution Range of degrees 67 Concepts, Goyal pp. 9-24

Geodesic distance between i and j is the shortest path between them Degree centrality is (degree)/(n1) Closeness centrality is (n-1)/(sum of distances of j from all other nodes) 68 Measures of importance of nodes and links Distance

Centrality Clustering coefficient (of A) is the small world phenomenon Probability that two randomly selected friends of A are friends with each other Methods of partitioning networks betweenness: what happens when a link is removed Can we apply this to bank collapses and systemic risk 69

Degrees of separation? 6? 70 Importance of Links: Neighborhood overlap = (Number of nodes who are neighbors of both A and B)/(Number of nodes who are neighbors of either A or B) = 1/6 applied to graph below: 71 72 Densely-connected, homogeneous parts that are weakly connected to each other 73 Homophily

p fraction of all individuals are male q (=1 - p) fraction of all individuals are female Consider a particular edge in this network If we independently assign each node the gender male with probability p and the gender female with probability q, then both ends of the edge will be male with probability p^2, and both ends will be female with probability q^2 = (1-p)^2 If the first end of the edge is male and the second end is female, or vice versa, then we have a cross-gender edge, so this happens with probability 2pq = 2p(1-p) Test for homophily according to gender as follows:

Homophily Test: If the fraction of cross-gender edges is significantly less than 2pq, then there is evidence for homophily. 74 Homophily example 5 of the 18 edges in the graph are cross-gender. p = 2/3, q = 1/3. We should compare the fraction of cross-gender edges to the quantity 2pq = 4/9 = 8/18. With no homophily, expect to see 8 cross-gender edges rather than 5, and so this example shows some evidence of homophily. 75 Week 3: The Internet

Economides, Nicholas (2007), The Economics of the Internet, in The New Palgrave Dictionary of Economics, London: Macmillan. Economides, Nicholas (2006), The Economics of the Internet Backbone , in Handbook of Telecommunications. Amsterdam: Elsevier Publishers. Easley and Kleinberg, ch. 13, 14, 15. 76 Basics on the Internet

Creation; History; Arpanet, NSF Structure, infrastructure Transmission; TCP/IP (transmission control protocol, UDP (user datagram protocol) Commercialization Pricing: transit and peering Internet Backbone Merger of MCI with WCOM Blocked merger of MCI with Sprint Present industry structure 77 Originally the Internet was connecting computers of defense

contractors and DoD computers Packet-switched not circuit-switched Information is cut to small information packets Based on simple transmission protocols TCP/IP (transmission control protocol) UDP (user datagram protocol)

Immediate delivery, but packets may be lost Because of nuclear attack threat at the time Guarantees delivery but may have delays Packets from A to B are sent in many routes Low security because nodes knew each other 78 DoD gave it to the National Science Foundation (NSF)

Later, in the early 1990s, commercialization Explosive growth; 1 bil devices (hosts) Backbone (long distance) network Internet Service Providers (ISPs) connecting to backbone Residential Business customers Upstream ISPs 79 Explosive growth of the Internet 80

Pricing by Internet Backbones (IBPs) to Internet Service Providers (ISPs) transit contract, delivers the whole Internet through a virtual pipe of a maximum bandwidth peering allows free exchange of info packets between two ISPs X and Y or two backbones Peering is limited to traffic originating or terminating at X or Y 81 82

US Lagging in Broadband OECD Broadband subscribers per 100 inhabitants, by technology, June 2009 40 35 DSL Cable Fibre/LAN Other 30 25 20 OECD 15 10 5

0 Source: OECD 83 USA Lags Behind Poorer Countries 84 BB market structure: US Carrier Traffic in Petabytes per month, May 2005 Company Market Share Among All Providers Traffic

1Q2004 2Q2004 3Q2004 4Q2004 4Q2004 A (AT&T) 37.19 38.66 44.54 52.33 12.58%

B 36.48 36.50 41.41 51.31 12.33% C 34.11 35.60 36.75 45.89

11.03% MCI 24.71 25.81 26.86 30.87 7.42% E 18.04 18.89 21.08

25.46 6.12% F 16.33 17.78 17.47 19.33 4.65% G 16.67 15.04

14.93 15.19 3.65% 188.28 203.04 240.38 57.78% 313 353 416 Total traffic top 7 networks

183.53 Total traffic all networks 313 85 Week 3: Cybersecutity and Privacy Nicholas Economides et al. (2010), Toward Better Usability, Security, a nd Privacy of Information Technolo gy , Committee Report, National Academies of Sciences. 86

Issues At present, the incentives of both users and companies on usable security and privacy diverge from actions that would maximize social benefit What economic and legal policies can be implemented to change users and companies incentives so that they are closer to maximizing social benefit? 87 Significant deficit in usable security and privacy

Current operating systems of PCs, netbooks, mobile phones, and other devices have significant security deficiencies Interfaces defining security levels are typically very difficult to follow Users are typically unaware of their level privacy (or its lack) in computers 88 The Internet has multiplied security problems of connected devices and highly increased the global impact of local lack of security

The Internet was designed for a small number of nodes that knew and trusted each other Presently we are almost at a billion nodes worldwide with no mutual knowledge and no trust The Internet has no centralized or Internet Service Provider (ISP)-level security Security issues have an even more severe impact in cloud computing Typical users have a very limited understanding of the network capabilities of their computers and the possibilities of abuse in a network setting 89 Perspectives of the Issue

The residential users point of view The business user point of view A search engines point of view The networks (societal) point of view Operating systems (OSs) and computer manufacturers point of view ISPs point of view Global issues 90 The users point of the view

Different computer communications, usage, and storage require different levels of security Does the user understand how secure or insecure his communications, usage, and storage are? Does the user understand the financial consequences to him and others of lack of security in these? How can the users understanding be enhanced? Does the user have sufficient economic incentives (rewards/punishments) to use sufficient security?

What is the balance between the users desire for privacy and the users desire for communication in social networks? Can we improve usability of security so that users who aim for higher security are able to achieve it? How? 91 Private companies have diverse points of view on security and privacy 1. Some businesses (e.g. banks, stock brokers, electronic commerce firms) generally desire higher security They have found various (private) solutions attempting to make their transactions more secure 2. But advertisers and search engines generally like more disclosure of private information to be able to pitch products closer to a consumer preferences and willingness to pay

A very secure Internet where users are fully aware of the impact of disclosures of their private information would cut into the profits of these companies 92 Private companies perspective (cont.) 3. OS companies typically grew up in the pre-Internet era OSs originally relied on third parties to beef up security OSs did not anticipate the potential for global damage created by multiple local infiltrations in a network setting in the presence of even small security flaws Ultimately, companies will act to avoid liability How should we tweak the law to change the incentives of

OS and computing devices manufacturers? Bottom line: Given the diverse uses of the Internet and the various functions/roles of firms on the Internet, it is unlikely to have a consensus among companies on security and privacy 93 From the networks point of view (societal point of view) In general, the value of security is much higher for the network than for an individual user Users, left on their own, will generally tend to achieve lower security than society desires Low security at a node can lead to catastrophic

network events (such as the collapse of attacked nodes or even parts of the Internet) that are much more damaging to society than to the individual node The lack of security at a node is a negative externality to the network 94 crucial divergence between private and social incentives on security Presently most users do not have sufficient incentives to secure their computers to prevent network-wide catastrophic events

Can we create sufficient economic incentives so that users aim for sufficient security? How? How can we improve usability of security so that users who aim for higher security are able to achieve it? 95 What incentives will induce users to more secure computing behavior? Positive monetary incentives (pay people)? Awards and other non-monetary positive incentives? Punishments for not meeting a security

benchmark? Impose on insecure nodes liability for damages created using their node? Limit access to the Internet if computer fails security test? 96 From the OSs and computer manufacturers point of view How can we create incentives for computer and operating systems vendors to increase security and maintain it through the useful life of a computer? 97

Should we require OSs to include and automatically update for free security/antivirus/anti-phishing? Should we impose additional liability on operating systems vendors? In the extreme, should we deny computers access to the Internet (except the security checkup and upgrade site) unless they have passed a minimal standard of security? Should we require OSs to disable (as the default) various server functions of new computers, network devices, mobile phones, etc.? 98

The ISPs point of view How can we induce ISPs to play a role in limiting or preventing some attacks while adhering to network openness and net neutrality? 99 Global Issues No matter how good security becomes within the U.S., security issues will remain because of the global nature of the Internet This underlines the importance

of certification of web sites and of measures that improve security in bilateral communications (including web browsing) of requirements on computer and OS manufacturers to increase security and automatically maintain it through the useful life of consumers worldwide 100 Policy Changes To strengthen usable security, what legal and economic policy changes are required

at the at the level? at the at the user level? computer and OS manufacturer web site/server level? Internet service provider level? 101 Some questions

How will the society deal with the negative externality on the network/society created by the lack of usable security of individual nodes? How can we provide positive and negative, monetary and non-monetary incentives to users to eliminate the negative externality? What role can the OSs play? Design? Postpurchase security maintenance? What role can the search engines play in making people aware of privacy issues? What role can ISPs play? 102 Week 4: Network structures and platforms; two-sided pricing

Economides, Nicholas The Economics of Networks , International Journal of Industrial Organization, vol. 16, no. 4, pp. 673-699 (October 1996). Economides, Nicholas, and Charles Himmelberg, (1995), Critical Mass and Network Evolution in Telecomm unications, in Gerard Brock (ed.), Telecommunications Policy Research Conference Selected Papers 1995. Shapiro and Varian chapter 7. 103 Special features of markets with network effects Increasing returns to scale in consumption (network effects) A market exhibits network

effects when the value of a transaction (or subscription) is higher when more units change hands, everything else being equal 104 Special features of markets with network effects: complementarities In a traditional network, network externalities arise because a typical subscriber can reach more subscribers in a larger network 105

Special features of markets with network effects: complementarities Network effects arise because of complementarities When customer A makes a phone call to customer B, he uses both AS and BS Although goods access to the switch AS, BS, , GS have the same industrial classification and traditional

economics would classify them as substitutes, they are used as complements 106 One-way and two-way networks Networks where services AB and BA are distinct are called two-way networks Two-way networks include railroad, road, and many

telecommunications networks When one of AB or BA is unfeasible, or does not make economic sense, or when there is no sense of direction in the network so that AB and BA are identical, then the network is called a one-way network In a typical one-way network, there are two types of components, and composite goods are formed only by combining a component of each type, and customers are often not identified with components but instead demand composite goods For example, radio and TV broadcasting and early paging networks are one-way networks 107 A long distance (two-way) network or an ATM (one-way) network 108 Virtual network or platform;

components Di complementary with components Sj; also has network effects In a virtual network, externalities arise because larger sales of components of type D induce larger availability of complementary components S1, ..., Sn, thereby increasing the value of components of type D Examples:

CPUs & monitors Users and advertisers in Yellow Pages or Internet search engines Razors and blades Cameras and film 109 Financial and other exchanges: network effects arise because market liquidity is desirable 110 Platforms 111 Technology platforms are the hubs of

the value chains in technology industries Examples of technology platforms: Microsoft Windows (PC operating systems) Intel processors (PC hardware) Sony PlayStation (game consoles) A platform forms the framework on which complementary goods (applications) attach (run) 112

Complementarity between a platform and applications APPLIC . A technology platform may be proprietary or open source PLATFOR M APPLIC . APPLIC .

Platform examples: Windows, Linux, iOS Application examples: MS-Office, Open 113 Office, iApps Two-sided pricing in markets with network effects Firms can make money from either side of a network or from both sides

from a server or a client (example: Adobe Acrobat and Adobe Reader) from a caller (typical) or a receiver (800 numbers) of a phone call or from both (cellular in U.S.) Internet backbones collect money from both parties that send and receive traffic (when not in a peering relationship) The availability of prices on both sides of the network allows for complex pricing strategies, and, depending on the dynamics and market shares on the two sides of the market, can be used strategically to enhance and leverage a firms strong strategic position on one side of the network 114

Weeks 5: Network Effects Under (Technical) Compatibility Economides, Nicholas The Economics of Networks , International Journal of Industrial Organization, vol. 16, no. 4, pp. 673-699 (October 1996). Economides, Nicholas, and Charles Himmelberg, (1995), Critical Mass and Network Evolution in Telecomm unications, in Gerard Brock (ed.), Telecommunications Policy Research Conference Selected Papers 1995. Shapiro and Varian chapter 7. 115

Complementarity and compatibility Links on a network are potentially complementary, but it is compatibility that makes complementarity actual Some network goods and some vertically related goods are immediately combinable because of their inherent properties However, for many complex products, actual complementarity can be achieved only through the adherence to specific technical compatibility standards

Thus, many providers of network or vertically-related goods have the option of making their products partially or fully incompatible with components produced by other firms This can be done through the creation of proprietary designs or the outright exclusion or refusal to interconnect with some firms As we will see, it is not always in the best interests of a firm to allow full compatibility of its products with those 116 of its competitors Network effects Nature How they arise Effects Consequences on competition,

market structure and profits 117 Sources of Network Effects (1) In traditional non-network industries, the willingness to pay for the last unit of a good decreases with the number of units sold. This is called the law of demand, and is traditionally considered to hold for almost all goods

However, the existence of network effects implies that, as more units are sold, the willingness to pay for the last unit may be higher This means that for network goods, the fundamental law of demand is violated: for network goods, some portions of the curve demand can slope upwards For some portions of the demand curve, as sales expand, people are willing to pay more 118 for the last unit Sources of Network Effects (2)

The law of demand is still correct if one disregards the effects of the expansion of sales on complementary goods But, as increased sales of a network good imply an expansion in the sales of complementary goods, the value of the last unit increases Combining the traditional downward slopping effect with the positive effect due to network expansion can result in a demand curve that has an upward-slopping part The key reason for the appearance of network effects is the complementarity between network components 119 Sources of Network Effects (3)

Depending on the network, the network effect may be direct or indirect When customers are identified with components, the network effect is direct Consider for example a typical two-way network, such as the local telephone network In this n-nodes 2-way network, there are n(n - 1) potential goods. An additional (n + 1th) customer provides direct network effects to all other customers in the network by adding 2n potential new goods through the provision of a complementary link to the existing links

In typical one-way networks, the network effect is only indirect When there are m varieties of component A and n varieties of component B (and all A-type goods are compatible with all of B-type), there are mn potential composite goods 120 An extra customer yields indirect network effects to Sources of Network Effects (4) Exchange networks (financial networks such as the NYSE and NASDAQ, commodities, futures, and options exchanges as well as business to business B2B exchanges) also exhibit indirect network effects There are two ways in which these network effects arise:

Network effects arise in the act of exchanging assets or goods Network effects may arise in the array of vertically related services that compose a financial transaction. These include the services of a broker, bringing the offer to the floor, matching the offer, etc. The second type of network effects are similar to other verticallyrelated markets The first way in which network effects arise in financial markets is more important The act of exchanging goods or assets brings together a trader who is willing to sell with a trader who is willing to buy

The exchange brings together the two complementary goods, willingness to sell at price p (the offer) and willingness to buy at price p (the counteroffer) and creates a composite good, the exchange transaction 121 Networks in finance References Economides, Network Economics with Application to Finance (1993) Economides and Schwartz, Electronic Call Market Trading (1995) Economides and Schwartz, Equity Trading Practices and Market Structure: As sessing Asset Managers Demand for Immediacy

(1995) Lange and Economides A Parimutuel Market Microstructure for Contingen t Claims Trading 122 (2000) Sources of Network Effects (5)

The two original goods were complementary and each had no value without the other one Clearly, the availability of the counteroffer is critical for the exchange to occur Put in terms commonly used in Finance, minimal liquidity is necessary for the transaction to occur Financial and business-to-business exchanges also exhibit positive size externalities in the sense that the increasing size (or thickness) of an exchange market increases the expected utility of all participants Higher participation of traders on both sides of the market (drawn from the same distribution) decreases the variance of the expected market price and increases the expected utility of risk-averse traders Higher liquidity increases traders utility 123 Network Effects Under Compatibility and Perfect Competition (1)

Let the willingness to pay for the nth unit of the good when ne units are expected to be sold be p(n; ne) n and ne are normalized so that they represent market coverage, ranging from 0 to 1, rather than absolute quantities Willingness to pay p(n; ne) is a decreasing function of n because the demand slopes downward p(n; ne) increases in ne; this captures the network externalities effect, i.e., that the good is more valuable when the expected sales ne are higher 124

Network Effects Under Compatibility and Perfect Competition (2) At a market equilibrium of the simple singleperiod world, expectations are fulfilled, n = ne, thus defining the fulfilled expectations demand p(n, n) Each willingness-to-pay curve p(n, nie), i = 1, 2, ..., shows the willingness to pay for a varying quantity n, given an expectation of sales ne = nie. At n = nie, expectations are fulfilled and the point belongs to p(n, n) as p(nie, nie) Thus p(n, n) is constructed as a collection of points p(nie, nie) 125 When there are strong network

effects, demand can slope upwards The law of demand, i.e., that higher output can be sold only at lower prices, is violated when there are significant network effects: demand curve can slope 126 Economides and Himmelberg, Critical Mass and Network Evolution in Tel ecommunications

(1995) show that the fulfilled expectations demand is increasing for small n if either one of three conditions hold: (i) the utility of every consumer in a network of zero size is zero; or (ii) there are immediate and large external benefits to network expansion for very small networks; or (iii) there is a significant number of high-willingnessto-pay consumers who are just indifferent on joining a network of approximately zero size

The first condition is straightforward and applies directly to all two-way networks, such as the telecommunications and fax networks where the good has no value unless there is another user to connect to The other two conditions are a bit more subtle, but commonly observed in networks and vertically127 related industries The second condition holds for networks where the addition of even few users increases significantly the value of the network A good example of this is a newsgroup on an obscure subject, where the addition of very few users starts a discussion and increases significantly its value

The third condition is most common in software markets A software application has value to a user even if no one else uses it The addition of an extra user has a network benefit to other users (because they can share files or find trained workers in the specifics of the application), but this benefit is small However, when large numbers of users are added, the network benefit can be very significant 128 Possibility that the demand does not start at zero

For goods that have a positive standalone value k without network effects, the demand starts at (0, k). 129 Critical Mass When the fulfilled expectations demand increases for small n, we say that the network exhibits a positive critical mass under perfect competition. If we imagine a constant marginal cost c decreasing as technology improves, the

network will start at a positive and significant size no (corresponding to marginal cost co) For each smaller marginal cost, c < co, there are three network sizes consistent with marginal cost pricing: a zero size network; an unstable network size at the first intersection of the horizontal through c with p(n, n); and the Pareto optimal stable network size at the largest 130 intersection of the horizontal with p(n, n) Market penetration of innovations is much faster in network industries than in non-network industries Penetration

network industry Non-network industry time Diffusion of an innovation with and without network effects 131 Multiplicity of Equilibria The multiplicity of equilibria is a direct result of the coordination problem that arises naturally in the typical

network externalities model The existence of an upward slopping part of the demand curve and the multiplicity of equilibria even under perfect competition also allows for a network to start with a small size and then expand significantly Suppose, for example, that marginal cost is at c < c o and a new invention creates a new product with significant network effects Then, it is possible that the industry starts at the left intersection of the horizontal at c with p(n, n) as expectations are originally low, and later on advances suddenly and quickly to the right intersection of the horizontal at c with p(n, n) Thus, the multiplicity of equilibria in network industries can lead to sudden significant expansions of network size 132 Efficiency (1)

In the presence of network externalities, it is evident that perfect competition is inefficient The marginal social benefit of network expansion is larger than the benefit that accrues to a particular firm under perfect competition Perfect competition (p = MC) will provide a smaller network than is socially optimal, and, for some relatively high marginal costs, perfect competition will not provide the good while it is socially optimal to provide it 133 Gross benefit (area under the demand) is B(n, n)

Marginal benefit of network expansion 134 Efficiency (2) Since perfect competition is inefficient, state subsidization of network industries is beneficial to society The Internet is a very successful network that was subsidized by the US government for many years The subsidized Internet was aimed at promoting

interaction among military research projects During the period of its subsidization, almost no one imagined that the Internet would become a ubiquitous commercial network The foundation of the Internet on publicly and freely available standards has facilitated its expansion and provided a guarantee that no firm can dominate it 135 Complex pricing: externalities internalized or not? Often the additional subscriber/user is not rewarded for the benefit that he/she brings to others by subscribing

Hence there may be externalities, i.e., benefits not fully intermediated by the market In some cases, externalities are fully intermediated through non-linear pricing Example: Cantor Fitzgerald pricing towards Salomon Brothers in secondary U.S. bonds market (before 2001) Typical trader paid $20 per $1 million face value Salomon paid $1 per $1 million face value plus a fixed fee Why? Salomon brought immense liquidity to the secondary market because it controlled 40% of the136

Mathematical example p(q, ne) = (1 q)ne q: actual units sold ne: expected size of sales Fulfilled expectations demand: p(n, n) = (1-n)n Marginal benefit of network expansion = n(1 - n) + n(1 - n/2) = n (2 3n/2) Notice that dB/dn > p. 137 The marginal benefit of network expansion is always higher than the willingness to pay of the last participant 0.7 0.6 0.5

0.4 0.3 0.2 0.1 0 0 0.1 0.2 0.3 0.4 p(n,n)

0.5 0.6 0.7 0.8 0.9 1 dB(n,n)/dn 138 If the good has a standalone value k > 0 p(q, ne) = (1 - q)(k + ne) p(n, ne) = c n = 1 c/(k + ne) p(n, n) = (1 - n)(k + n) dB(n, n)/dn = (1-n)(k+n)+n(1-n/ 2)

Perfect comp: p(n, n) = c n*(c) = [1-k+((1+k)^2-4c))]/2 139 Fulfilled expectations 140 Adoption S-curves from various network industries 141 Weeks 6-7: Technical Standards Competition and the Compatibility Decision

Paul David and Shane Greenstein (1990), The Economics of Compatibility Sta ndards Nicholas Economides and Fredrick Flyer, (1998) Compatibility and Market Structure for Network Goods 142 Why is technical standards competition important? Because of network effects Network effects create inequality Competing standards that have small

market share can be marginalized When a company chooses to be incompatible, it makes a big difference where it stands in the inequality chain of incompatible firms 143 Technical standards competition VHS vs. Beta Windows vs. Mac vs. Linux MP3 vs. WMA vs. RealAudio HD DVD vs. Blu-Ray

iPhone vs. Android vs. Windows 8 144 Technical Compatibility when various links and nodes on the network can be costlessly combined to produce demanded goods Two complementary components A and B are compatible when they can be combined to produce a composite good or service Two substitute components A1 and A2 are compatible when each of them can be combined with a complementary good B to produce a composite good or service

Example: we say that a VHS-format video player is compatible with a VHS-format tape Example: two VHS tapes are compatible; two VHS video players are compatible Similarly we say that two software products are compatible (more precisely two-way compatible) when they each can read and write files in a common format Compatibility may be one-way when the files of format B1 of software A1 can be read by software A2 , but the files format B2 of software A2 cannot be read by software A1 Moreover, compatibility may be only partial in the sense that software A1 is able to read files of format B2 but unable to write files in that format.

145 Dichotomy in markets with network effects (1) Full compatibility networks Voice telecommunications (by regulation) Internet data communications (by design) Fax (by design) Cars and gasoline (by market

evolution) Tables and chairs (by market evolution) 146 Dichotomy in markets with network effects (2) Incompatible networks

Operating Systems for PCs (Windows, Mac OS X, Linux) Game platforms (Xbox, Sony, Nintendo) Digital audio formats (iPod, Windows Media Player WMA, MP3, RealAudio) High definition DVDs (HD-DVD, Blu-ray) Video players (Betamax, VHS) Information servers (Google, MSN, Yahoo, yellow pages) Financial and other exchanges 147 Path-dependence is the dependence of a system or network on past decisions of producers and consumers Todays sales of Windows are path-dependent because they depend on the number of Windows sold earlier (the installed base Windows). The existence of an installed base of consumers favors an incumbent However, competitors with significant product

advantages or a better pricing strategy can overcome the advantage of an installed base Example: VHS overcame Beta after six years of higher installed base by Beta Sonys mistakes in disregarding network externalities and not licensing the Beta format JVCs widespread cheap licensing of VHS A low-end, low-price VHS player can contribute as much

to the network effect as a high-end high-price Beta player 148 Strategic Choices of Technical Standards and Compatibility In Network Industries Standards Wars (1) A key strategic decision for a firm is the extent to which it will be compatible with other firms A network good has higher value because of the existence of network effects

Different firms conforming to the same technical standard can create a larger network effect while still competing with each other in other dimensions (such as quality and price) The decision to conform to the same technical standard is a strategic one A firm can choose to be compatible with a rival and thereby create a larger network effect and share it with the rival. A firm could alternatively choose to be incompatible with the rival, but keep all the network effects it creates to itself 149 Standards Wars (2) 1.

2. 3. 4. 5. Which way the decision will go depends on a number of factors: In some network industries, such as telecommunications, interconnection and compatibility at the level of voice and low capacity data transmission is mandated by law The decision will depend on the expertise that a firm has on a particular standard (and therefore on the costs that it would incur to conform to it) The choice on compatibility will depend on the relative benefit of keeping all the network effects to itself by choosing incompatibility versus receiving half of the larger network benefits by choosing compatibility. The choice on compatibility depends on the ability of a firm to

sustain a dominant position in an ensuing standards war if incompatibility is chosen The compatibility choice depends on the ability of firms to leverage any monopoly power that they manage to attain in a regime of incompatibility to new markets. 150 Standards Wars (3) Standards may be defined by the government (as in the case of the beginning of the Internet), a world engineering body (as in the case of the FAX), an industry-wide committee, or just sponsored by one or more firms Even when industry-wide committees are available, firms have been known to

introduce and sponsor their own standards Incentives of firms to choose to be compatible with others; coordination game 151 Standards war leading to compatibility (1) Full compatibility at both non-cooperative equilibria Standard 1 is a non-cooperative equilibrium if a > e, b > d. Similarly, standard 2 is an equilibrium if g > c, h > f.

In this game, we will assume that firm i has higher profits when its standard i get adopted, a > g, b < h. Profits, in case of disagreement, will depend on the particulars of the industry. One standard assumption that captures many industries is that in case of disagreement profits are lower than those of agreeing on either standard, e, c < g; d, f < b 152 Standards war leading to compatibility (2) There is no guarantee that the highest joint profit standard will be adopted Since consumers surplus does not appear in the matrix, there is no guarantee of total surplus maximization at equilibrium

153 Standards war leading to incompatibility Compatibility with competitors brings higher network externality benefits (network effect) and therefore is desirable. At the same time, compatibility makes product X a closer substitute to competing products (competition

effect), and it is therefore undesirable. In making a choice on compatibility, a firm has to balance these opposing incentives. Firms want to differentiate their products because they want to avoid intense competition. In a network industry, the traditional decisions of output and price take special importance since higher output Inequality in market shares and profitability is a natural consequence of incompatibility Under incompatibility, network externalities act as a quality feature that differentiates the products 154 Markets with strong network effects where firms can choose to be incompatible are winner-takes-most markets In these markets, there is extreme market shares and profits inequality The market share of the largest firm can be a multiple of the market share of the second largest, the second largest firms market share can be a multiple of the

market share of the third, and so on Example: 66%, 22%, 7%, 2.%, 1%, Geometric sequence of market shares implies that, even for small n, the nth firms market share is tiny Examples: PC operating systems market; software applications markets Why? A firm with a large market share has more complementary goods and therefore its good is more

valuable to consumers Why winner-takes-most and not winner-takes-all? Because to take all requires an undesirable cut in price 155 Winner-takes-most markets

When fixed costs are small, a very large number of firms can survive, but there is tremendous inequality in market shares, prices, and profits among them Examples of this market structure are the PC operating systems market and many software applications markets Setup of Economides and Flyer (1998) All firms produce identical products, except for what value is added to them by network effects No firm has any technical advantage in production over any other with respect to any particular platform and no production costs Pure network goods where there is no value to the good in the absence of network externalities Consumers are differentiated in their willingness to pay for the network good 156 With network effects, natural

inequality: winner-takesmost Markets for incompatible products have inequality Hits in blogs Hits in Internet engines Market share of firms in traditional Yellow pages Size distribution of connections of Internet hosts Because of natural inequality in the market structure of network industries, there should

be no presumption that anti-competitive actions are responsible for the creation of market share inequality or very high profitability of a top firm No anti-competitive acts are necessary to create this inequality 157 Profits inequality and network effects under incompatibility. k = value of the good with no network effects Profits of Top 3 Firms in a Market with High Network Externalities (k=0), one firm per coalition P rofits 0.16 Pie1 Pie2 Pie3

0 0 2 4 6 8 10 Number of Firms in Market Profits of Top 3 Firms in a Market with Low Network Externalities (k=1), one firm per coalition Profits

0.5 0.4 Pie1 0.3 Pie2 0.2 Pie3 0.1 0 0 2 4 6

8 10 Number of Firms in Market 158 Herfindahl-Hirschman (H) Index for Different Intensities of Marginal Network Externality 1/k and Numbers of Firms S Under Incompatibility No network effect 0 .463 .333 .2 .1

0 No network effect (1/k = 0) implies equal firm shares, si = 1/n and H index: H = in=1 si2 = 1/n 159 Inequality of market shares and prices under incompatibility for pure network goods (k = 0) 160 Profits, Consumers and Total Surplus under incompatibility for pure network goods (k = 0) Ratios of profits of consecutive firms range from 15 to 20 161 Monopoly May Maximize Total

Surplus When here are fewer firms in the market there is more coordination and the network effects are larger As the number of firms decreases, the positive network effects increase more than the dead weight loss, so that total surplus is maximized in a monopoly! Total surplus is highest while consumers surplus is lowest in a monopoly This poses an interesting dilemma for antitrust authorities

Should they intervene or not? In non-network industries, typically both consumers and total surplus are lowest in a monopoly In this network model, total maximizing consumers surplus would imply minimizing total surplus 162 No Anti-Competitive Acts are Necessary to Create Market Inequality

In network industries, free entry does not lead to perfect competition Antitrust and competition law have placed a tremendous amount of hope on the ability of free entry to spur competition, reduce prices, and ultimately eliminate profits In network industries, free entry brings into the industry an infinity of firms but it fails miserably to reduce inequality in market shares, prices and profits Entry does not eliminate the profits of the high production firms Imposing a competitive market structure is likely to be counterproductive 163 Strategic Choice of Compatibility in Duopoly Profits Under Incompatibility and Compatibility 0.45 0.4 0.35

P rofits 0.3 0.25 0.2 0.15 Pie2 0.1 Pie1 0.05 Pie Compatibility 0 0 0.2

0.4 0.6 0.8 1.1 k 1.4 1.7 2.1 2.5 2.9 k

Equilibria in a Two-Firm Industry 164 Competition for the market takes precedence over competition in the market Intense competition on which firm will create the top platform and reap most of the benefits Example: Schumpeterian races for market dominance among dot-coms in 1999-2000

Very high valuation of dominant vs. other dot-com firms in that period; Wall Street perception Strategic effect: firms advertised very intensely and subsidized consumers to achieve a dominant position 165 Week 7: Bottlenecks and Interconnection Pricing Nicholas Economides, Giuseppe Lopomo and Glenn Woroch, Strategic Commitments and the Principle of Reci procity in Interconnection Pricing , chapter 5 (pp. 62-99), in Gary Madden (ed.) The Economics of Digital Markets, Edward Elgar (2009).

Nicholas Economides, Giuseppe Lopomo and Glenn Woroch, Regulatory Pricing Policies to Neutralize Network Dominance , Industrial and Corporate Change, vol. 5, no. 4, pp. 1013-1028, (1996). 166 One-sided bottlenecks The early (1900) AT&T owned links 1 (long distance) and 2 (local), but did not allow independent firms which possessed link 3 to interconnect at B and provide part of the long distance service ABC For over two decades in the beginning of the 20th century, AT&T refused to interconnect independent local telecommunications companies to its long distance network, unless they became part of the Bell System, resulting in 89% market share for AT&T by 1935 from about 50% in 1914 In the 1970s AT&T controlled 89% of local lines and almost all long distance (LD)

AT&T faced competition in LD by MCI which did not have local lines AT&T provided low quality interconnection to local lines to MCI 167 Interconnection Pricing; Vertical Price Squeeze Assume use of link 1 is required by links 2, 3

Goods 12 and 13 and substitutes Assume link 1 is monopolized by firm A which also owns link 2, while firm B owns link 3 Firm B owns only link 2 and needs to buy use of link 1 from A Firm A sets the price p(12) of end-to-end service 12 and the interconnection or access price p(1) of link 1 when sold to firm B The price-to-cost margin of B is p(12) p(1), both controlled by firm A, and can be made as small as firm A wants Firm B can be marginalized of driven out of business

168 Two-sided bottlenecks Each of two firms is monopolist, each with a different bottleneck, and each firm requires the others bottleneck to produce its output Two local telephone companies, each customer subscribes only to one local telephone company, and each company requires the others

network to complete calls Calls originate at A1, A2 and terminate at B1, B2. Termination charges at B1, B2 for calls from the rival network can be used to disadvantage and foreclose the rival network Example: New Zealand Problem in U.S. telecommunications solved by setting equal termination fees (reciprocity); unresolved in ATM, credit card, and other unregulated networks 169 Leveraging of market power across markets Various types of exclusionary arrangements Instruments:

Technical standards Bundling and other pricing strategies Non-price discrimination strategies (raising rivals costs) 170 Limited effects of antitrust policy In markets with strong network effects, once few firms are in operation, the addition of new competitors, even under free entry,

does not change the market structure in any significant way Although eliminating barriers to entry can encourage competition, the resulting competition may not significantly affect market structure In markets with strong network effects, antitrust authorities may not be able to significantly affect market structure by eliminating barriers to entry 171 Leveraging Example In the middle 1980s, Nintendo refused to allow third party games (software) to play on its

game console (hardware) unless the software manufacturers agreed not to write a similar game for two years for competing game systems Nintendo used the dominance of the game market at the time to coerce developers to write software just for its platform, and thereby to increase the value of the Nintendo virtual network (of hardware and software) Practice stopped under threat from DOJ 172 Issues in after-markets where consumers are locked-in in a durable good or service arises out of commitments of durable nature Examples

refusal of Kodak to supply to repair companies replacement parts for Kodak photocopiers lack of email address portability for ISPs lack of number portability for wireless phones long after it was feasible 173 Example from computing industry: subsidizing complementary goods

Firm A chooses to make its product incompatible with others Firm A subsidizes firms that produce complementary goods Alternatively, firm A subsidizes its division that sells complementary goods As a result The value of firm As product increase The entry hurdle of firm As rivals increases Possible creation of market power, but action also has pro-competitive justification 174 Impose compatibility?

Incompatibility is a necessary condition for possible creation of market power Key to increasing social welfare: public standards, compatibility But, it is very difficult for US antitrust authorities to intervene and/or define standards Different in the EU which is trying to impose compatibility between Microsoft and Sun servers (MS and Linux servers are compatible) Imposing compatibility may reduce incentives to innovate

The dynamically incorrect standard may be chosen If forced to choose a single standard, the FCC would have chosen TDMA or GSM at the first PCS auctions CDMA proved more efficient later on 175 Dynamic efficiency issues Static efficiency may lack in dynamic efficiency Possibility of a lock-in to a technology which, when decisions taken in every

period, looks optimal given past decisions, but is sub-optimal if decisions are delayed and all the decisions are taken at once Lock-in may occur as a consequence of the race to be a dominant firm in a network industry 176 Innovation issues Efficiency and intensity of innovation in monopoly compared to competition and oligopoly is an open question in economics 177 Regulation?

178 When should regulation be used? Regulation it is best suited for industries with well defined and not changing products and services Regulation is not well suited in industries with rapid technological change and frequently changing product definitions Regulation can be used by the regulated companies to keep prices relatively high, as

exemplified by telecommunications regulation Often regulators are very close to the interests of the regulated parties rather than to the interests of the public Often regulators are not well informed about key variables as well as changes in the industry 179 When should regulation be used? Regulators at both the state and federal levels are under pressure and influence by both the executive and the legislative part of government, and cannot be as impartial as a

court There is a tendency for regulators to expand their reach into related and new markets These drawbacks can create significant surplus loss due to regulation However, regulatory rules can and should be used effectively and appropriately in cases of dominance or monopolization of essential network bottlenecks to assure that firms do not leverage their monopoly to adjacent markets that prices are not too high 180 Week 8

(a) Taxicabs; (b) Electric cars 181 (a) Taxi cabs as a twosided network Traditionally taxicabs (yellow cabs) are hailed on the street their prices are regulated number of licenses is regulated; no entry allowed lack of entry sometimes leads to very high value of licenses (over $1mil in

NYC) price of license is a fixed cost to the 182 driver Parallel markets Pre-arranged rides Town cars Black cars Liveries (in NYC above 96th Street and outside Manhattan) Each fleet uses incompatible dispatch systems

183 New entrants, direct substitute for taxicabs Locations of cabs online using an app Customers hail cabs with the app based on location/distance No price regulation Advantage: see free cabs further than the usual 2-3 blocks Uber charges according to demand/supply

imbalance Regulatory issues at some municipalities 184 (b) Electric cars as a twosided network Network issue because they need a network of fuel stations Alternatives Fast charges at gas stations and home Replaceable batteries at gas stations

Precedent in electric taxicab fleets in New York and Philadelphia Cars purchased from GE without a battery and Hartford Electric Light Company provided batteries and replacement 185 Week 8-9: (a) Payment Systems in US and EU; (b) mobile banking in Africa; Nicholas Economides (2009), Competition Policy Issues in the Consumer Payments Industry , in Robert E. Litan and Martin Neil Baily, eds., Moving Money: The Future of Consumer Payment Brookings Institution.

Alan S. Frankel and Allan L. Shampine, The Economic Effects of Interchange Fees , Antitrust Law Journal 73, no. 3: 62773. US DOJ press release, Settlement with Visa and MasterCard ; United States v. American Express. Nicholas Economides and with David Henriques (2012), To Surcharge or Not to Surcharge? A Two-Sided Market Perspecti ve of the No-Surcharge Rule, NET Institute Working paper #11-03, August 2011 186 (a) Payment Systems, Electronic Transaction Facilitation in US & EU Bank cards facilitate transactions between merchants and consumers

Some cards also offer credit The market for facilitation of transactions is dominated by the card networks Visa and MasterCard Stand-alone cards American Express and Discover smaller Visa 42%, MasterCard 29%, American Express 24%, Discover 5% (US market shares) Card networks collect significant fees from merchants to facilitate transactions Cards charge (non-credit-related) fees (primarily to merchants) significantly above cost

Some estimate total cost only 13-15% of revenue Fees $30-48 billion per year in U.S. 187 Three-parties Setup (American Express, Discover) American Express $10 0 $9 Consumer 7 Merchant

Goods worth $100 188 Four-parties Setup (MasterCard, Visa) Issuing Bank $98. 5 Interchange fee $10 0 Acquiring Bank $9 Consumer 8

Visa network Merchant Goods worth $100 189 Three Markets in Sequence in Four-parties Setup Issuing Bank Market I Market II Acquiring Bank Interchange fee Market III

Consumer Visa network Merchant Goods worth $100 Market III is generally considered effectively competitive, but since the interchange fee is the marginal cost of the acquiring bank, the interchange fee is a floor to the fees merchants pay In Market II, the network sets the maximum interchange fee

Practically no bank in the network deviates from it No market determination of the interchange fee in bilateral markets between an acquiring and an issuing bank Issuing banks have market power in Market I but 190 manage to make merchants pay through markets II and High Price-to-cost Markups Despite Non-Dominant-Firm Market Shares Very significant markup of price above cost Very unlikely that consumers receive from card networks anything

approaching the fee levels charged to merchants Comparable with profit rates of Microsoft and Intel But these have an almost monopoly market share 191 How does Visa with 42% market share Networks make sure that the consumers do not face directly the cost of their transactions so that they cannot choose to use the

lowest fee card the merchants cannot charge different prices to reflect the card fees if consumers use different cards and different cards have different fees 192 The card networks Impose contractual obligations on merchants that Effects

do not allow merchants to respond to differences in fees across cards do not allow the card holders to choose which card to use based on the cost the transaction imposed on the merchant (since the merchant is not allowed to pass this along) Card transactions are subsidized by cash transactions High cost card transactions are subsidized by low cost card transactions Significant market distortion 193 Networks to Restrict Competition

and Achieve High Fees (1) No surcharge rule (Visa contract, 2008) A merchant can charge the same for a Visa transaction as for cash If a merchant offers a discount for cash compared to Visa, he cannot offer the same discount to a comparable card (MasterCard) If a merchant offers a discount to a comparable card, he has to offer the same discount to Visa (most favored customer rule)

Effect of the rule: the merchant cannot offer better terms to customers who buy with MasterCard than with Visa (although it may make sense to do so if MasterCards fees are lower) No price flexibility allowed in the merchants pricing As if Coca Cola imposed the requirement that a can of Pepsi be sold at the same price as a comparable can of Coke Only option for the merchant is not to accept a 194 Networks to Restrict Competition and Achieve High Fees (2)

No discrimination rule MasterCard: Merchants may not engage in acceptance practices or procedures that discriminate against, or discourage the use of, MasterCard cards in favor of any other card brand .... 195 Networks to Restrict Competition and Achieve High Fees (3) Card networks relied on a most-favoredcustomer (MFC) rule so that all prices among comparable network cards were the same

IO theory has established that mostfavored-customer rules can be used to facilitate price increases to collusive levels, Salop (1986) Reason: Under MFC rules, a firm will lose more revenue if it cuts price to a customer than in the absence of MFC rules 196 High fees are shielded through the honor all cards rule Debit networks (typically with PIN

verification) offer lower merchant fees Debit cards of MasterCard and Visa also offer much lower fees than the signature-based credit cards To avoid loss of profits in credit cards, the networks impose the requirement that if a merchant accepts a Visa (say debit) card, he also has to accept all Visa cards (part of honor all cards rule) 197 Networks imposed the Honor all cards rule A merchant accepting a Visa debit card issued by Citibank also has to accept

Visa Debit cards issued by any other Visa network bank Any Visa products, such as Visa credit cards (tying) Visa's rules stated that [t]he Merchant shall promptly honor all valid Visa cards when properly presented as payment .... Anti-competitive consequences of tying What if Microsoft said that if your corporation buys Windows, it also has to buy MS-Office Or if you buy Dell servers you also have to buy Dell 198 laptops?

Effects of old equilibrium Card transactions are subsidized by cash transactions High cost card transactions are subsidized by low cost card transactions Networks have incentives to keep increasing interchange fees to attract more issuers 199 Proposed Changes in the Market Between Merchants and Acquiring Banks (Market III) Allow for competition between branded networks

Abolish the no surcharge rule Abolish the no discrimination rule Abolish the honor all cards rule 200 Proposed Changes in the Market Between Acquiring and Issuing Banks (Market II)

Allow the market between issuers and acquirers to determine the interchange fee Bilateral negotiations between pairs of banks (issuer and acquirer) Start from a par position (zero interchange fee) 201 Hold-out problem An issuer with very valuable potential transactions demands monopoly fee from acquirers Not a problem if monopoly power of issuer

is legitimate Isolated problem if the proposal is adopted rather than market-wide problem under present regime Competition among issuers for these valuable customers solves the problem in the long run as these customers get more 202 than one card Effects of Proposed Changes Increased inter-network and intranetwork competition likely to result in lower transaction facilitation fees 203 Australian Experience

The Reserve Bank of Australia reduced interchange fees for credit cards in Australia from 0.95% to 0.55% in 2003 and to 0.50% in November 2006 Allowed surcharging Results: merchant fees fell even more than the interchange fees the overall cost to the economy of facilitating transactions fell 204 More radical changes

Separating authentication from payment Large merchants eliminate acquirers? 205 In Sept. 2010, DOJ sued Visa, MasterCard and Amex over the no-surcharge rule Visa and MasterCard settled, accepting to abolish the nosurcharge and no discrimination clauses of their contracts

Amex said it did nothing wrong; suit U.S. v. Amex continues Impact on merchants who do not take Amex? 206 EU actions, July 2013 EU payment market is worth 130bn euros EU wants to cap interchange fees to a maximum of 0.3% of a transaction Debit card fees to 0.2% of a transaction See http:// www.bbc.co.uk/news/business-2343154 207 3

(b) Mobile banking in Africa and other developing areas Read: Seeking Fertile Grounds for Mobile M oney 208 Many households do not have traditional bank accounts A new bank account can be created and attached to a mobile phone number

and therefore to a mobile telecom network Each mobile network creates its own money Mobile banking networks are incompatible When are two mobile telecom companies, A, B, in a country, there are three types of money: State (S-) money, A- m-money, and B- m-money 209 De facto lack of interoperability makes exchange rates crucial. In Tanzania:

Conversion from S- money to A- or B- mmoney (cashing in) is free Conversion from A- or B- m-money to Smoney (cashing out) is expensive: fee 2.5% for an average transaction Transfer across networks, from A- money to B- money is even more expensive, fee 2.8% for average transactions Transfer within a network has a low fee, 0.3% for average transactions Substantial surplus losses because of de facto lack of interoperability 210 In Tanzania 35% of households have at least one m-money account

three major m-banking networks Vodacom (Vodafone), 53% market share in mmoney Tigo, 18% Airtel, 13% Calling and transferring money across networks is expensive, many consumers have a different phone or a different SIM for each network Tigo advertises phones that take multiple SIMs 211

M-money is most frequently used to send or receive remittances Non-remittance transfers are infrequent 14% of all households made or received a non-remittance payment in the past six months using any type of cash delivery, including m-money The most common types of payments included school fees, government fees and taxes, utility bills, and salaries 212 Despite the zero interest

rate Half of consumers with m-money accounts use their account as a savings account 21% Vodacom M-Pesa users and 12% of users of Tigo & Airtel use m-money for business transactions 213 Cashing in and cashing out of m-money is done through a network of fixed and roaming agents that act as

ATM machines This is the main cost of the banking networks 214 Data 3 months of banking transactions from Tigo Tanzania, including cash-in, cash-out, recharge mobile, transfer, check balance Balance, operation size, GPS location, fee

During the period, there was an unanticipated price change in transfer and cash-out fees 215 Tanzania 216 Frequency of transfers 217 Transfer network 218 Cash is a close substitute for short distance transfers. Elasticity of demand for m-transfers decreases with distance. 219

Probability of an mtransfer increases with distance 220 Summary of results Long distance transfers more inelastic, 1.25 vs. 1.55 Transaction taxes 0.25% transaction tax lowers the propensity to transfer by 46% 10% tax on the transfer fee lowers the propensity of transfers by 13% Taxes are extracted from long distance remittances

regressive tax Interoperability with zero cash-out fee would 221 increase the propensity for m- transfers by 1% Week 10: The Digital Books Market Market Structure Distribution model of digital goods DOJ suit and EU statement of objections against Apple and five publishers

US Complaint Settlement of publishers Court decision on Apple 222 History and Market Structure 1992 Sony sells Data Discman, an eBook reader for CDs 2000 Microsoft launches Microsoft Reader, works in Windows

2007 Amazon launches Kindle 2010 Apple launches iPad 2011 Barnes and Noble launches Nook 223 Book sales revenue 2012, eBooks surpass hardcover 224 Retail price for ebooks used to be set by retailer (Amazon, etc.) Publisher collects price P per

eBook Retailer sets price R to users Price R for most ebooks > P, but sometimes R < P Before the iPad came to market, Amazon sold NYT bestsellers for R = $9.99, below P 225 Publishers did not like low R Even though they still collected P > R Why?

Because most of the book sales were of hard copies, and the hard copy price Ph was much larger than R Publishers were worried that they may have to reduce price Ph (say $35) in the presence of an eBook price of $9.99 Before the iPad came to market, in Dec. 2009 publishers retaliated against Amazon by withholding availability of new releases as ebooks for a few months after hard copies of new books were being sold, a practice called windowing But windowing encouraged piracy 226 In the months before the launch of the iPad Apple was in intense negotiations with publishers attempting to convince them

To adopt the agency pricing model To impose this model to all retailers, including Amazon To allow for ebooks of NYT bestsellers to become available at the same time as hard copies 227 To cut the price of eBook NYT Once the iPad entered the market

the 5 major publishers and Apple agreed to move to the agency pricing model on the condition that it would apply to Amazon too Agency pricing model: Retail price R is set by publisher Retailer keeps 30% of the retail price, i.e., P = (0.7)R Similar to the way Apple sold third party software for the iPad through its virtual store 228 publishers for conspiring to set eBook prices (April 2012). Defendants:

Hachette Book Group, Inc. HarperCollins Publishers L.L.C. Simon & Schuster, Inc. Macmillan Penguin group The above settled; Remaining defendant Apple 229 Apple CEO Steve Jobs to Publisher Defendants: Well go to [an] agency model,

where you set the price, and we get our 30%, and yes, the customer pays a little more, but thats what you want anyway. (p. 4 of US complaint) 230 Effects of the conspiracy The increases at Amazon within roughly two weeks of moving to agency amounted to an average per unit eBook retail price increase of 14.2% for their New Releases, 42.7% for their NYT Bestsellers, and 18.6% across all of the Publisher Defendants e-books Court decision on Apple, page 94

231 Prices increased as a result of the conspiracy 232 Ebook prices before and after the conspiracy agreement 233 Strength of DOJs case Conspiracy (Section 1 of Sherman Act), no need to show anti-competitive effects) Weakness of the case

Apple can claim it was imposed to it by the publishers DOJ could have brought criminal charges but did not Shows that DOJ did not believe it could win a criminal case 234 Settlement approved 9/7/12 Ends conspiracy among publishers Allows eBook retailers to set price (as they used to) Settling publishers agreed

to refrain for two years from entering into contracts containing retail price restrictions and price commitment mechanisms to stop communicating competitively sensitive information to competitors not retaliate against retailers that exercise discounting authority not to fix terms or prices with competitors for the provision of ebooks AGs of various states get $69 million damages from publishers 235 Similar case in EU settled

On 9/7/12, Apple and four major publishers (all US defendants except Penguin) have offered to allow retailers such as Amazon to sell e-books at a discount for two years On 11/6/12, Reuters reports that EU is about to settle on these terms 236 In July 2013, US District Court decision finds Apple liable

of conspiracy to restrain trade in violation of Section 1 of the Sherman Act Civil suits to follow Need additional study of prices after the end of the conspiracy 237 DOJ proposal on remedies: Apple is required to end its existing eBook agreements with five major publishers

and sign no new price-setting distribution contracts for five years allowed to continue to sell ebooks prohibited from retaliating against publishers for refusing to sell ebooks under terms approved by Apple required to allow other eBook sellers, such as Amazon and Barnes & Noble, to give more prominent play to their eBook stores on Apple devices, by allowing them to provide links from their eBook apps to their eBook stores prohibited from entering into agreements with suppliers of ebooks, music, movies, television shows or other content that are likely to increase the prices at which Apple's competitor retailers may sell that content See http:// www.computerworld.com/s/article/9241316/DOJ_AGs_propose_remedies_for_Apple_in_e_book _price_fixing?source=CTWNLE_nlt_pm_2013-08-02 238 Week 11: Two-sided Pricing & Network

Neutrality General theory Application to network neutrality Public policy References: Economides & Tag, Network Neutrality on the Internet: A Two-sided Market Analysis, Information Economics and Policy (2012), at http://www.stern.nyu.edu/networks/Economides_Tag _Net_Neutrality.pdf Economides and Hermalin (2012), The Economics of Network Neutrality, forthcoming, Rand Journal of Economics, at

http://www.stern.nyu.edu/networks/Economides-H ermalin_Economics_of_Network_Neutrality.pdf 239 In networks, price discrimination schemes can be complex (1) Because a network may have different degrees of market power on different sides of the market A firm that controls a proprietary platform

sets a price strategically for its end-user products and collects a fee for complementary products to its platform sold by other firms Sony controlling its game console sets a price for the game console and charges royalties to developers of games Microsoft sells Windows to end-users provides application developers with information and resources; embeds subroutines in Windows useful to application developers makes money from licensing application development tools and support 240

Prices and fees in twosided markets p0 user platform APPLIC p 1 . price p1 , p2 , p3 user s1 application prices PLATFOR p M 0 s1 , s2 , s3 fees to s s 2

3 APPLIC platform (or . subsidies to applications) p2 APPLIC . p3 241 In networks, price discrimination schemes can be complex (2)

Since the creation of the Internet, there was no price (or other) discrimination based on what service or what application the bits came from (so called net neutrality) Now AT&T, Verizon and cable TV networks advocate price discrimination based on which application and on which provider the bits come from AT&T, Verizon and cable TV networks propose to kill net neutrality by charging both the DSL subscriber and the application provider (such as Google) where the bits originate, even when the application provider is not directly connected to AT&T or Verizon (i.e., Googles ISP is not AT&T or Verizon) Note that the proposal is to impose price discrimination on the provider side of the market and not on the subscriber (i.e., it is a version of two-sided pricing) 242

Two-sided Pricing & Network Neutrality ISP Netflix Google Internet Internet Backbone Backbone ISP p s : AT&Ts fee to content providers or many fees s1, s2, , sn Residential

Customers AT&T (Access Network) R: subscription pri 243 Interview with Ed Whitacre BusinessWeek November 7, 2005 How concerned are you about Internet upstarts like Google, MSN, Vonage, and others? How do you think they're going to get to customers? Through a broadband pipe. Cable companies have them. We have them. Now what they would like to do is use my pipes free, but I ain't going to let them do that because we have spent this capital and we have to have a return on it. So there's going to have to be some mechanism

for these people who use these pipes to pay for the portion they're using. Why should they be allowed to use my pipes? The Internet can't be free in that sense, because we and the cable companies have made an investment and for a Google or Yahoo! or Vonage 244 But Both Sides Pay for Transit on the Internet All hosts on the Internet pay according to bandwidth use: there is no free lunch on the Internet AT&T, Verizon, and others are paid by ISPs according to bandwidth use

Actually Internet backbones are paid twice for any transmission, by the originator of traffic and by the terminator of traffic (through their respective ISPs) 245 Varying Levels Of Network Neutrality, from Strictest to Weakest Referring to pricing to the other side of the consumer market (that is to content and applications providers): 1. Absolute non-discrimination: no quality of service variations offered for money or for free 2. Varying quality of service offered according to type of info. packet but no fees are charged 3. Tiered service allowed but each tier is offered at the same price to all; no exclusivity or identitybased discrimination 4. Identity-based discrimination allowed 5. Exclusivity allowed 246

Obamas statement on NN, at http://www.barackobama.com/pdf/issues/technolog y/Fact_Sheet_Innovation_and_Technology.pdf Barack Obama strongly supports the principle of network neutrality to preserve the benefits of open competition on the Internet. Because most Americans only have a choice of only one or two broadband carriers, carriers are tempted to impose a toll charge on content and services, discriminating against websites that are unwilling to pay for equal treatment. This could create a two tier Internet in which websites with the best relationships with network providers can get the fastest access to consumers, while all competing websites remain in a slower lane. Such a result would threaten innovation, the open tradition and architecture of the Internet, and competition among content and backbone providers. It would also threaten the equality of speech

through which the Internet has begun to transform American political and cultural discourse. Barack Obama supports the basic principle that network providers should not be allowed to charge fees to privilege the content or applications of some web sites and Internet applications over others. This principle will ensure that the new competitors, especially small or non-profit speakers, have the same opportunity as incumbents to 247 innovate on the Internet and to reach large audiences. FCCs NPRM (2009) (1): Subject to reasonable network management, a provider of broadband Internet access service may not 1. prevent any of its users from sending or receiving the lawful content of the users choice over the

Internet. 2. prevent any of its users from running the lawful applications or using the lawful services of the users choice. 3. prevent any of its users from connecting to and using on its network the users choice of lawful devices that do not harm the network. 4. deprive any of its users of the users entitlement to competition among network providers, application providers, service providers, and content providers. 248 FCCs NPRM (2009) (2): Subject to reasonable network management, a provider of broadband Internet access service must treat lawful content, applications, and services in a nondiscriminatory manner

We understand the term nondiscriminatory to mean that a broadband Internet access service provider may not charge a content, application, or service provider for enhanced or prioritized access to the subscribers of the broadband Internet access service provider We propose that this rule would not prevent a broadband Internet access service provider from charging subscribers different prices for different 249 services. FCC Rule (December 2010)

1. Transparency: Fixed and mobile broadband providers must disclose the network management practices, performance characteristics, and terms and conditions of their broadband services. 2. No blocking: Fixed broadband providers may not block lawful content, applications, services, or non-harmful devices; mobile broadband providers may not block lawful websites, or block applications that compete with their voice or video telephony services. 3. No unreasonable discrimination: Fixed broadband providers may not unreasonably discriminate in transmitting lawful network traffic. Even though this regulation is weak, Verizon appealed to stop it. In Jan. 2014, Verizon won, and the FCC rules were nullified. 250 EU: Directive 2009/140/Ec 25 November 2009 Commission Declaration On Net Neutrality

The Commission attaches high importance to preserving the open and neutral character of the Internet, taking full account of the will of the co-legislators now to enshrine net neutrality as a policy objective and regulatory principle to be promoted by national regulatory authorities alongside the strengthening of related transparency requirements and the creation of safeguard powers for national regulatory authorities to prevent the degradation of services and the hindering or slowing down of traffic over 251 EU: Directive 2009/140/Ec 25 November 2009, Consultation, and Kroes Speech

National Regulatory Authorities are required to promote the ability of endusers to access and distribute information or run applications and services of their choice National Regulatory Authorities, after consulting the Commission, can set minimum quality of service requirements Strong transparency to ensure 252 consumers understand and get what Residential ISPs have market power; also claim congestion Assuming no congestion, Economides and Tag (2009) and others showed that introducing a positive price to content providers is typically welfare-inferior to NN

Economides & Tag, Network Neutrality on the Internet: A Two-sided Market Analysis, Information Economics and Policy (2012), at http://www.stern.nyu.edu/networks/Economides_Tag_Net_ Neutrality.pdf ISPs claim that NN is not optimal with congestion Issue addressed in Economides and Hermalin (2012), The Economics of Network Neutrality, Rand Journal of Economics, at http://www.stern.nyu.edu/networks/Economides-Herma lin_Economics_of_Network_Neutrality.pdf 253

Six Consequences of Departure from Net Neutrality 1. Introduction on the Internet of twosided pricing where a transmission company controlling some part of the Internet (here last mile access) will charge a fee to content or application firms on other side of the network Economides and Tag (2012) main result: Starting to charge a positive price s on the other side of the market is desirable to an access monopolist (or duopolists) but not desirable for society more later in the presentation 254 Six Consequences of Departure from Net Neutrality

2. Introduction of prioritization which may enhance the arrival time of information packets that originate from paying content and application firms on the other side, and may also degrade the arrival time of information packets that originate from non-paying firms The present plans of access providers are to create a special lane for the information packets of the paying firms while restricting the lane of the nonpayers without expanding total capacity By manipulating the size of the paying firms lane, the access provider can guarantee a difference in the arrival rates of packets originating from paying and non-paying firms, even if the actual improvement in arrival time for paying firms packets is not improved over net neutrality 255 Six Consequences of

Departure from Net Neutrality 3. If the access providers choose to engage in identity-based discrimination, they can determine which one of the firms in an industry sector on the other side of the network, say in search, will get priority and therefore win This can easily be done by announcing that prioritization will be offered to only one of the search firms, for example the one that bids the highest Thus, the determination of the winner in search and other markets on the other side will be in hands of the access providers and not determined

by innovative products or services on the other side This can create very significant distortions since the surplus on the other side of the Internet is a large multiple of the combined telecom and cable 256 Six Consequences of Departure from Net Neutrality 4.New firms with small capitalization (or those innovative firms that have not yet achieved significant penetration and revenues) will very likely not be the winners of the prioritization auction This is likely to reduce innovation. Network externalities arise because a

typical subscriber can reach more subscribers in a larger network Under no net neutrality, access providers can limit the size and profitability of new firms on 257 Six Consequences of Departure from Net Neutrality 5. The access networks can favor their own content and applications rather that those of independent firms Examples: independent VOIP, video This is likely to distort competition and reduce total surplus

258 Six Consequences of Departure from Net Neutrality 6. Since the Internet consists of a series of interconnected networks, any one of these, and not just the final consumer access ones, can, in principle, ask content and application providers for a fee This can result in multiple fees charged on a single transmission and lead to a significant reduction of trade on the Internet 259 Economides-Tag (2012) deals with two-sided pricing when there is no congestion

In terms of potential welfare reduction because of the six effects discussed above, we model the case that has the least reduction in total surplus compared with net neutrality Even though we make the best possible case for total surplus to increase when departing from net neutrality (by not focusing on factors two to six that are likely to reduce surplus), we find that typically total surplus decreases, both in monopoly and duopoly when we depart from net neutrality 260 Stylized model: Money flows Content / Applications

Providers s Platform (ISP) p R Consumers 261 Crucial Questions

Does the platform want to set s >0? Does the platform want to set s1, s2, etc.? Are consumers better/worse off at s > 0 vs. s = 0 Are consumers better/worse off at s1 > s2 > 0 vs. s = 0 Is total surplus (TS = CS + Profits of ISP + Profits of Apps) higher with s > 0 than s = 0? With s1 > s2 > 0 vs. s = 0? 262 Model 1 (Economides and Tag, 2012)

Network effects from the consumers to the apps and vice versa Monopolistic competition among apps Monopoly or duopoly ISP No congestion Heterogeneous consumers Heterogeneous apps Network effect from consumers to apps a Network effect from apps to consumers b 263 Platform incentives in setting fee sM to other side of the market Content Providers sM b = value (network effect) of extra content

provider to a consumer a>bs >0 M Platform RM > 0 Consumers Internet consumers, access platform, and content providers Game platform consumers, game platform, and games a = value (network effect) of extra consumer to a content provider a < b sM < 0

PC users, operating system, and applications Credit card issuing banks, credit card platform, and 264 consumers Optimal One-sided Regulation in the Presence of Monopoly on the Other Side of the Market A regulator/planner setting a fee s to content providers expecting the platform monopolist to set his profit-maximizing subscription price p(s) maximizes the constrained total surplus function TS(p(s), s)

and chooses a below-cost fee to content providers s***< 0 provided that both consumers and content providers are sufficiently differentiated Even paying the below-cost fee, the platform makes positive profits Similar results for duopoly ISPs 265 Economides-Hermalin assumes congestion Examines under what conditions NN is optimal What pricing does the ISP implement? 266

Model 2 (Economides and Hermalin, 2012) Assume congestion: If traffic exceeds the pipes capacity it gets delayed proportionately Monopoly ISP Homogeneous consumers Heterogeneous apps Below: welfare = total surplus TS TS = CS + profits of ISP + profits of apps Because the consumers are homogeneous,

the ISP appropriates all CS 267 Define net neutrality as no division of the bandwidth Otherwise, bandwidth is divided in lanes, and each lane is allocated to one or more apps Provided that the monopolist ISP allows (sells to) all apps: Neutrality is weakly welfare-superior to any division of the bandwidth in which all segments are allocated a positive portion of the bandwidth Neutrality is strongly welfare-superior to any

division that excludes some segments 268 A bandwidth allocation is welfaresuperior if it carries more content Consider divisions of bandwidth in lanes Proposition 1. Given two alternative divisions of the total bandwidth, one is welfare superior to the other if and only if it results in more content being carried in equilibrium than the other. Corollary 1. Network neutrality is welfare superior to any division of the bandwidth if no division of the bandwidth leads to more content being sent in equilibrium. 269

Amount of content carried is a sufficient statistic for welfare and how bandwidth is allocated to content does not matter Content is analogous to income, and it has the maximum positive effect on welfare when it is allocated as the consumer sees fit without restrictions Restrictions (special lanes etc.) in its allocation restrict welfare [Reminiscent of Varian (1985,9) showing that third degree price discrimination increase welfare vis-a-vis uniform pricing only if it increases the total amount of goods sold] 270

Exclusion reduces welfare Proposition 2. Suppose the ISP provides a common class of service, but excludes a positive measure of content providers. In the resulting equilibrium, TS is less than it would be were no content providers excluded. 271 Allowing the ISP to charge a positive fee to apps will exclude some apps

Each user likes more applications When the consumer surplus is higher, the ISP (who appropriates consumer surplus) has an incentive to allow more apps Each app wants fewer (other) apps because more apps congest the network and delay delivery This externality among apps is not internalized in this model 272 Welfare = Total Surplus = Consumer Surplus + Profits of ISP + Profits of Apps

A necessary condition for welfare under price discrimination to exceed welfare is that the set of application providers served in equilibrium expand If the ISP serves all application providers in equilibrium under linear pricing, then any non-trivial price discrimination scheme reduces welfare 273 The effect of prioritization on total surplus Depends on how the elasticity of demand with respect to transmission time varies with content type NN can maximize welfare

if the elasticity of demand with respect to transmission time is invariant with respect to content But depending on how that elasticity varies with content type, to max. welfare you may want to prioritize or slow down content of high immediacy desire 274 Crucial issue is how many apps at the bottom are excluded when fee to apps is introduced i.e., depends on the distribution of app

types Welfare can be higher or lower in price discrimination vs. linear pricing, depending on parameters Of course, higher welfare requires more total content sales 275 Dynamic Issues: investment in bandwidth ISP invests more in bandwidth with single positive fee to apps than with no fee With single positive fee, ISP invests less in bandwidth compared to the welfare-maximizing amount

ISP invests more in bandwidth with price discrimination than with single positive fee to apps 276 Distinction between static and dynamic efficiency Example where (app types by desirability of immediacy) is distributed uniformly on [.05,1]. Given a fixed bandwidth, compelling ISP to serve all application providers would raise welfare by 10% Cost of bandwidth B (unrealistic technology)B (unrealistic technology) Unrestricted ISP will build 1.649 times as much

bandwidth as it would were it constrained Greater bandwidth does not fully overcome the static inefficiency, but, once the dynamic consequences are considered, welfare with zero fee is only 2% greater than were the ISP unrestricted 277 In some models (Choi and Kim, Rand Journal 2010), ISP can have higher profits if it restricts bandwidth Lower bandwidth can increase the difference between the price of a good in the fast lane vs. slow lane Not in Economides-Hermalin 278

Conclusions on net neutrality (1) Two-sided pricing is complex Identified conditions when prices are positive on both sides and when one side is subsidized Generally, social welfare diverges from platform profits On the Internet, net neutrality typically is welfare-maximizing 279 Conclusions on net neutrality (2)

Under reasonable assumptions, welfare increases in the total amount of content carried Even in the presence of congestion, NN can maximize welfare if the elasticity of demand with respect to transmission time is invariant with respect to content But depending on that elasticity, to max. welfare you may want to prioritize or slow down content of high immediacy desire Killing NN can increase bandwidth investment and reduce the static allocative distortion

280 Week 12: Bottom line 281 Companies strategies that were successful in network industries 1. Vertical extension of the company 2. Discount pricing based on volume to take advantage of network effects 3. Discount pricing based on volume to take advantage of dominant position and disadvantage competitors 4. Subsidizing complementary goods 5. Control of bottlenecks 6. Exclusive contracts 282 1. Vertical extension of the company

Example: Microsoft 92% market share in operating systems for PCs Over time, it added functions to the OS that used to be independent applications or middleware: Browser Windows Media Player Hard disk defragmenter

Anti-spyware Anti-virus But MS does not go in hardware in PCs; is aware of its core competency 283 Advantages of extending the firm vertically Offensive advantage Takes away value from complementary goods and adds value to own product Defensive advantage

Avoids complementary goods firms creating a challenge to own product Netscape browser + Java might challenge Windows 284 Disadvantages of extending the firm vertically Strategy may be illegal as in the Microsoft cases in the US and EU But strategy very likely legal if market

share is < 50% in US and < 40% in EU Vertical extension could distract from the core competency of the firm 285 Microsoft against Netscape which saw its share going from 100% to 0% But, so-and-so in audio players 286 2. Discount pricing based on volume to take advantage of network effects

Example: Cantor Fitzgerald in the secondary market for US government bonds; had 70+% share Offered per unit pricing very significantly above marginal cost to all traders except Salomon Brothers Salomon was offered marginal cost pricing plus a fixed fee Why? To get the very high liquidity of Salomon that had 40+% in primary market, and internalize the network 287 effects Success?

Very successful for Cantor Kept dominant position despite an inefficient trading platform (broker matching vs. electronic trading) Primary dealers had to set up their own exchanges as a threat to constrain the per-unit pricing of Cantor 288 to take advantage of dominant position and disadvantage competitors

Example: Microsofts per processor pricing before 1995 Offered Windows at a per unit price, say $30 Also offered Windows to a PC manufacturer, say Compaq, that produced say 1 mil. units, at a flat price of $24 mil. with the right to install in all units For Compaq, the last 200,000 units effectively had zero price Compaq had a strong incentive not to 289 buy from competitors (IBM) Advantages

When marginal cost is very low, this strategy can rapidly increase market share (as it did for Microsoft) Great success for Microsoft that marginalized DOS competitor DRDOS; increased the market share of Windows (that faced IBMs OS2) to 90+% 290 Disadvantages The strategy is likely to be illegal

for a dominant firm in the US, EU, Japan, and Korea In 1995 (before the big antitrust suit) Microsoft agreed with USDOJ to stop using this strategy But, it is a legal strategy for nondominant firms 291 4. Subsidizing complementary goods Example: Microsoft It chooses to make its product (OS) incompatible with others

It subsidizes firms that produce complementary goods (by including in Windows features that are useful to application developers but not to users) Alternatively, MS subsidizes its division that sells complementary goods (Office) As a result The value of MSs product increases The entry hurdle of MSs rivals increases 292 Advantages of subsidizing complementary goods Offensive advantage

Defensive advantage The value of own product increases The entry hurdle of rivals increases It can make a platform dominant Huge mistake of Apple not to adopt this strategy when Bill Gates pushed Apple to adopt it (before the creation of Windows) Refusal by Apple prompted MS to create Windows and made MS the key player in 293 Disadvantages of subsidizing

complementary goods It costs money that may not be recoverable for some time However, as Microsoft showed, subsidizing complementary goods can create dominance in the long run with very large benefits 294 5. Control of bottlenecks Is crucial for creation and

maintenance of dominant market position Sometimes innovation can eliminate the bottleneck Example: software services can eliminate the bottleneck of OSs 295 Old software model with OS bottleneck Windows OS Apple OS X Linux OS Windows Application Software Mac

Application Software Linux Application Software Windows dominant Application needs OSspecific APIs 296 New software service model eliminates/reduces the bottleneck Apple OS Windows OS

Linux OS Browser Application as a Service Windows dominant Open standards Based on browsers open standards OS market structure irrelevant for

service application 297 6. Exclusive contracts Example: Microsoft Exclusive contracts with AOL and other ISPs on adoption of Internet Explorer Successful but illegal for a dominant firm 298 Some Big Upheavals in Network Industries 1. Google in Internet search/advertising

2. iPod big success in digital audio 3. VHS killing Betamax 4. Internet Explorer displacing Netscape 5. Alternating current displacing direct current in electricity 299 Being first is no guarantee of long run success Examples Google in Internet search

Arrived very late Used a different algorithm for search Based its revenue on advertising Apples iPod Also arrived very late Hardware-software combination More liberal contract on legal copies (at the time) 300 Betamax/VHS: Sonys strategic error VHS video recorder (JVC/Matsushita)

Came later than Betamax (Sony) Was widely licensed; low price Betamax was not widely licensed; high price Much bigger network effects of VHS After 5 years, Betamax withdraws from the USA Strategic error of Sony Originally video recorders were used for time-shifting (like Tivo) there were no

network effects Only later movies for rental appeared -crucial complementary good creating network effects Sonys managers missed the transition 301 Internet Explorer displaces Netscape Originally Netscape (based on Mosaic of the Univ. of Illinois) was dominant with 90+% market share Microsoft makes a huge effort to write better browser from scratch

IE3 was significantly better than Netscape Microsoft uses exclusive contracts and bundling in Windows to boost IEs market share 302 Alternating current displacing direct current in electricity Originally electricity generation and distribution was developed as direct current (DC) by Edison

Significant municipal networks (New York City, Philadelphia) were created based on DC Light bulbs last much longer on DC Westinghouse pushed AC because its motors run much more efficiently on AC AC won because of the efficiency of its long distance transportation (Niagara Falls to NYC) 303 Bottom line (1) 1. Incompatibility is key 2. Under incompatibility, winner-takesmost 3. Crucial to have the top market share 4. Competition for the market more important than competition in the market; make early sacrifices 5. Extend the firm vertically without going outside core competences 304

Bottom line (2) 6. Use price discrimination to a. take advantage of network effects b. take advantage of or create dominant position c. disadvantage competitors 7. Subsidize complementary goods to create a dominant platform 8. Try to keep control of bottlenecks; create new bottlenecks if possible 9. May use exclusive contracts if legal 305 Weeks 12: Antitrust in Networks Industries 3 Microsoft cases The Microsoft Antitrust Case For MBA Students

NYU conference on US v. MS, including streaming video of all presentations featuring ( among others) Assistant Attorney General for Antitrust Doug Melamed, NY Assistant A ttorney General for Antitrust Harry First, Microsoft counsel Rick Rule and Former Solicit or General Boyden Gray Discussion on US v. MS on PBS TV with host Jim Goodale, Prof. Nicholas Economides, a nd Prof. Eleanor Fox, in streaming video, first broadcast on November 16, 2000 Story in Wired magazine on Microsofts proposal for Apple allow clones Nicholas Economides & Ioannis Lianos, A Critical Appraisal of Remedies in the EU Microsoft Cases, Columbia Business Law Review 2010/2:346-420 (2010). Nicholas Economides & Ioannis Lianos, The Quest for Appropriate Remedies in the Microsoft Antitrust EU Cases: A Comparative Ap praisal , Microsoft on Trial: Legal and Economic Analysis of a Transatlantic Antitrust Case, Luca Rubini (ed.). Edward Elgar (2010). Nicholas Economides & Ioannis Lianos, The

Elusive Antitrust Standard on Bundling in Europe and in the United States at the After math of the Microsoft Cases 306 , Antitrust Law Journal 76/3:483-567 (2009). Microsoft Antitrust Calendar: Early Fights 1991-93: FTC investigates MS twice, but does takes action 1994-95: DOJs investigation ends in a 1995 settlement

Key provisions: 1. Microsoft agrees to end per-processor (zero marginal price) contracts with OEMs but can use unrestricted quantity discounts 2. Microsoft shall not enter into any License Agreement in which the terms of that agreement are expressly or impliedly conditioned upon the licensing of any other Covered Product, Operating System Software product or other product (provided, however, that this provision in and of itself shall not be construed to prohibit Microsoft from developing integrated products); or the OEM not licensing, purchasing, using or distributing any non-Microsoft product. That is, no product bundling allowed by contract, but Microsoft can keep expanding the functions of its products, including Windows 307 Main U.S. Fight (1)

1997: Senator Orin Hatch (R-Utah) holds congressional hearings on Microsoft featuring Gates, Barksdale, Dell. Sen. Hatch takes the position that if present antitrust law cannot deal with Microsoft, Congress should change or enhance the antitrust laws Sun, Oracle, IBM, Netscape, and Novell form a loose coalition lobbying for antitrust action 1997: DOJ alleges anti-competitive bundling of IE with Windows (violation of 1995 decree) Dec. 1997: Judge Thomas Penfield Jackson issues preliminary

injunction barring bundling of IE with Windows 98 May 12, 1998: Court of Appeals (DC Circuit) decides that 1995 decree doesnt apply to Windows 98, which was shipped with integrated IE May 18, 1998: DOJ and 20 states and the District of Columbia file the main antitrust case 308 Main (U.S.) Fight (2)

Nov. 5, 1999: Judge Jackson issues findings of fact, siding very strongly with the plaintiffs Dec. 1999: Prominent antitrust scholar, Judge Richard Posner appointed mediator for settlement discussions April 1, 2000: Settlement talks break down after States hold out in proposed agreement. April 3, 2000: Judge Jackson issues conclusions of law June 7, 2000: Judge Jackson orders breakup of Microsoft in two companies February 27, 2001: DC appeals court hears appeal June 28, 2001: DC appeals court reverses breakup September 6, 2001: DOJ seeks quick settlement without breakup November 2, 2001: DOJ and Microsoft propose settlement; nine states settle and nine do not March 18, 2002: Nine litigating states start remedies trial in front of Judge Colleen KollarKotelly November 1, 2002: Judge Colleen Kollar-Kotelly rules that the proposed settlement serves the public's interest and rejects positions of litigating states November 29, 2002: All states except Massachusetts and West Virginia accept the settlement; eventually, both Massachusetts and West Virginia agree with the settlement

309 Microsofts business then Software Operating systems for PC (Windows 95, 98, NT, 2000) Operating systems for local network and Internet servers (Windows NT, 2000) Back-office products for network and Internet servers Internet Clients

Internet Servers Desktop applications (Office, Word, Excel, Access, PowerPoint, MSMoney, etc.) Games Programming languages (Visual Basic, Java) Hardware Mice, keyboards Services Internet service (MSN, WebTV) Internet content (MSN) 310 Product support The allegations. Microsoft accused of: 1. Monopolization of the market for operating systems (OSs) for PCs; ( 2, Sherman Act)

2. Anti-competitive contractual arrangements with various vendors of related goods such as with computer manufacturers and Internet Service Providers (ISPs) and other actions taken to preserve and enhance its monopoly; ( 2, Sherman Act) 3. Attempting monopolize the market for Internet browsers (but failing to succeed); ( 2, Sherman Act) 4. Anti-competitive bundling of the Internet Explorer (IE), with the Windows operating systems; ( 1, Sherman Act) 311 Monopolization under 2 of the Sherman Act is illegal if the offender took anti-competitive actions to acquire, preserve, or enhance its monopoly

Sherman Act 2: Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony. Modern interpretation: For monopolization, plaintiffs have to prove that the defendant 1. Possesses market power 2. Willfully acquired or maintained this monopoly power as distinguished from acquisition through a superior product, business acumen, or historical accident 312 Attempting to monopolize is illegal (Sherman Act, 2) Bundling, and, more generally, price discrimination

could be illegal if it has anti-competitive consequences Exclusionary contracts could be illegal if they have anti-competitive effects To prove attempting to monopolize (under Sherman Act 2), plaintiffs have to prove that the defendant 1. Engaged in predatory or anti-competitive conduct 2. with specific intent to monopolize 3. and that there was a dangerous probability that the defendant would succeed in achieving 313 Findings of fact and conclusions of law The judges findings of fact (Nov. 1999) and conclusions of law

(April 2000) found for the plaintiffs (US DOJ and 19 States) in almost all the allegations against MS The judge found: Microsoft has a monopoly in the PC operating systems market (for Intel-based computers) where it enjoys a large and stable market share Microsoft used its monopoly power in the PC operating systems market and harmed competitors Microsoft hobbled the innovation process Microsoft actions harmed consumers Various Microsoft contracts had anti-competitive implications, but MS is not guilty of anti-competitive exclusive dealing contracts hindering the distribution of Netscape 314 On June 7, 2000, after an extremely short hearing, Judge Jackson issues his remedies decision:

split Microsoft into two companies, one for operating systems (Windows 98, NT, and 2000), and one for all the rest, including applications (MSOffice, etc.) impose business conduct restrictions 315 Judge decided that MS has monopoly power in the OS market for Intel compatible PCs

Problem: Low price of OS; if Microsoft is able to exercise monopoly power, why does it not exercise it through price? If the price of PC hardware is pH and the demand elasticity is ||, the monopoly price of ||, the monopoly price of , the monopoly price of Windows is pW = pH/(||, the monopoly price of ||, the monopoly price of - 1) If pH = $1,800 and ||, the monopoly price of ||, the monopoly price of = 2, pW = $1,800, while the actual price to OEMs was $40-60 Requires a very large demand elasticity of ||, the monopoly price of ||, the monopoly price of = 31 to get a monopoly price of pW = $60 316 Possible explanations for the low price of Windows

To hook consumers but when will MS increase the price? Competition from installed base of Windows but (i) very difficult to uninstall Windows (ii) consumers buy much better new PCs faster than traditional obsolescence rates would imply (iii) Windows price is small compared to the PC+Windows bundle To reduce pirating but why is then MS-Office price high? Because it allows for higher prices of complementary goods but MS does not monopolize all the complementary goods markets, therefore it would be optimal to charge the monopoly price on Windows Because of the existence of actual and potential 317 competition Monopoly may maximize social surplus when there are network externalities present under conditions of incompatibility; value of de facto standardization

318 Microsoft appealed, and was granted a stay of all parts of the District Court decisions until the appeal is heard Summary of court of appeals decision: Microsofts breakup and other remedies imposed by the District Court were vacated

Microsoft was found liable of monopolization of the operating systems market for PCs Microsoft was found not liable of bundling Microsoft was found not liable of attempting to monopolize the Internet browser market The district court judge Thomas Penfield Jackson was taken out of the case for improper behavior The case was remanded to the District Court for remedies determination for the monopolization charge 319 Bundling issue The Appeals Court instructed the District Court to examine the bundling of IE and Windows (if plaintiffs bring it up) under a rule of reason where the consumer benefits of bundling are balanced against the damage of anti-competitive actions

In face of the Appeals Court decision, DOJ decided not to pursue the bundling issue and announces that it will not ask for a breakup of Microsoft 320 The Settlement: On November 6, 2001 the United States, the states of New York, Illinois, North Carolina, Kentucky, Michigan, Louisiana, Wisconsin, Maryland and Ohio, and Microsoft announced a settlement California, Connecticut, Iowa, Massachusetts, Minnesota, West Virginia, Florida, Kansas, Utah, and the District of Columbia pursued the suit further to a full remedies trial (started March

11, 2002) in front of U.S. District Judge Colleen Kollar-Kotelly These States proposed making the source code of Windows and IE public, freezing Windows so that additional functionality would be sold as an additional good, making all APIs public, and other severe remedies. On November 12, 2002, Judge Colleen Kollar-Kotelly imposed the final judgment that had only small differences from the original proposed settlement 321 Settlement terms A. Provisions seen as favorable to Microsoft 1. 2. 3. 4. No breakup

Microsoft can expand functions of Windows No general restrictions on bundling No mandatory disclosure of source code B. Provisions seen as favorable to the plaintiffs 1. Broad scope of definition of middleware products (including browser, e-mail clients, media players, instant messaging software, etc.) 322 Settlement terms (cont.) 2. Requirement to partially disclose middleware interfaces Microsoft is required to provide software developers with the interfaces used by Microsoft's middleware to interoperate with the operating system 3. Requirement to partially disclose server

protocols The settlement imposes interoperability between Windows and non-Microsoft servers of the same level as between Windows and 323 Microsoft servers. Settlement terms (cont.) 4. Freedom to install middleware software Computer manufacturers and consumers will be free to substitute competing middleware software on Microsoft's operating system. 5. Ban on retaliation Microsoft prohibited from retaliating against computer manufacturers or software developers

for supporting or developing certain competing software 324 Settlement terms (cont.) 6. Uniform pricing of Windows for same volume sale Microsoft will be required to license its operating system to key computer manufacturers on uniform terms for five years. Microsoft will be allowed to provide quantity discounts. 7. Ban on exclusive agreements; contract restrictions Microsoft will be prohibited from entering into agreements requiring the exclusive

325 support or development of certain Microsoft Multi-year investigation of MS by the EU on interoperability between non-Microsoft servers and Windows clients bundling of Windows Media Player with Windows The EU (i) Found Microsoft liable on both issues (ii) Imposed a $609 million fine (iii) Required MS to produce a version of Windows without WMP (called Windows-N) but without a requirement to sell it for less than Windows (iv) Required MS to make public and license at a low price the communications protocols between Windows clients and non-Windows servers 326 Less than 2000 copies of Windows-N were sold

Second EU case on browser In December 2007, Opera (an Internet browser) brings the issue of Microsoft bundling IE with Windows to the EU In January 2009, the EU issues a statement of objections to Microsoft, alleging a violation of Article 82 EC for tying IE to Windows Given the previous decision on WMP, liability of

Microsoft seems certain Microsoft offers to sell Windows 7 without any browser pre-installed (users would use FTP to download browser) Proposal rejected by the EU in favor of a choice 327 Choice screen Is imposed through Windows update on all users in the EU who are using IE as a default (on all Windows products)

Will allow users choice among IE, Firefox, Safari, Opera, and Chrome On December 16, 2009, the Commission accepted the final choice screen proposal, and the matter ended In my opinion, the choice screen should have been made available to all, not just IE users Present solution gives incentives to bribe OEMs to choose a non-IE default browser, so the choice screen 328 does not appear Investigations of Google FTC investigation, leaked two weeks before presidential election to create the impression that Obama was tough on antitrust

EU investigations Both, mainly on placement in organic search Aggregators Placement of search results of Google affiliates Agreements with Android manufact. 329 US investigation fizzled FTC accepted proposed commitment Google proposed to clearly label the links of its affiliates

(A joke!) EU Investigation continuing and recently got extended 330 4/15/2015, EU sues Google Sent Google a Statement of Objections Allegations: Google favors its own comparison shopping services (for airline tickets, hotels, etc.) by placing them on top of

the first organic search page Vertical issue, may be hard for EU to win 331 Allegations cont. Google demoted placement of aggregators such as Foundem 332 EU launched Android investigation. Allegations:

Google required that smartphone and tablet manufacturers exclusively pre-install Google applications on their devices Prevented the success of rival apps by bundling its own apps and services on Android devices with other Google applications Prevented manufacturers who want to use Google apps from developing and marketing modified and potentially competing versions of Android on other devices 333 Week 12: Bank Networks Formation and Systemic Risk 334 Network Structure and Collapse

The network gets formed in anticipation of good and bad times Bad times eliminate nodes with prob. Pb As Pb increases, banks form ex ante more dense networks expecting more widespread collapses in bad times Pb increase is more costly to the each bank because it has to create a more dense network ex ante If Pb is underestimated, the prob. of collapse of any node of the formed network increases 335 Possibilities of Collapse (= Node Leaving the

Network) Individual nodes can collapse both in good and bad times Collapse of Bi increases the probability of collapse of a connected node Bj There can be cascading collapses For the same network structure, cascading collapses increase as the probability of shocks increases336 Network Structure It pays to have more connections because more

connections make it more likely to find a trading partner (to diversify risk (Allen and Gale)) and therefore less likely for any node to collapse In bad times, there are fewer nodes to connect to, so less diversification of risk But fewer connections could restrict a cascading collapse to only a cluster of nodes by limiting the propagation of the financial distress (Battiston et at.) Higher connectedness could also degrade credit worthiness and increase financial distress 337 Public Policy to Reduce Impact of Collapses in Bad Times

Network-specific recommendations Collect data on interconnected banks (and other institutions that have similar functions) and identify the network structure Analyze the banking sector as a network structure Assess the risk to a bank from further-away neighbors in the network Identify central nodes whose collapse can have very significant impact on the network 338

Systemic Risk as a Network Issue Our Model First, banks B1, B2, , Bn form a network by checking the credit worthiness of each other at a cost and in anticipation of subsequent trading Second, the state of the world is revealed, Good = g or Bad = b

Let Pg < Pb be the prob. of unacceptably high credit risk A bank (node) with unacceptably high credit risk collapses (or, equivalently, no one trades with it) Third, in each of M periods, each bank receives a positive or negative shock with prob. q If, in the same period, directly connected banks Bi and Bj receive opposite shocks they trade at low cost If banks Bi and Bj are not connected directly but only through other nodes they trade at a higher cost, and the intermediate nodes benefit too If bank Bi receives a positive or negative shock and cannot find anyone to trade with, it trades with the Fed at a high cost 339 340

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