Tutorial: Network Externalities

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Welcome to the Network Externalities Tutorial.

Note: in order to run the dynamic simulations referred to in this tutorial, go here, to the Java Applet version. You will be directed to download the latest version of the Java plug-in.

"Network Externalities, Competition, and Compatibility" by Michael L. Katz and Carl Shapiro (The American Economic Review, Volume 75, Issue 3; June 1985; 424-440) offers an economic model that captures the effects of network externalities in a market economy. This tutorial demonstrates a way of using calculus principles and agent-based simulation to pinpoint the equilibria implied by this model.

TABLE OF CONTENTS

  1. Introduction
    1. Connecting to a Phone Network
    2. Network Externalities Cause Positive Feedback
    3. Another Common Example
    4. The Katz and Shapiro Model of Network Externalities
    5. Fulfilled Expectations Cournot Equilibria
  2. Two-Firm Scenario
    1. Two Firms with Incompatible Products
    2. Searching for Several Equilibria
    3. Two Firms with Compatible Products
    4. Analysis of the Two-Firm Equilibria
  3. Increasing Compatibility Among Three Firms
    1. Three Firms with Incompatible Products
    2. Three Firms under Partial Compatibility
    3. Three Firms under Full Compatibility
    4. Effect of Increased Compatibility
  4. Strength of the Network Externality
    1. A Monopolist Facing Network Externalities
    2. Strong Network Externality Facilitates Monopolies
    3. Weakening the Network Externality Function to Destabilize a Monopoly
  5. Excess Inertia and Cross-Model Validation
    1. A Game-Theoretic Model of Switching Standards
    2. Excess Inertia
    3. Relating Two Models of Network Externalities
    4. Demonstration of Excess Inertia
  6. Closing Remarks
  7. Technical Appendix
    1. Equilibrium Reaction Correspondence Curve
    2. Complete Incompatibility, Partial and Complete Compatibility
    3. Equilibrium Modes, Equilibrium Ranges
    4. Implementing the Newton's Method Procedure in the Simulator

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