Introduction

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Another Common Example

In the example of a telephone service provider, network externality arises from the direct physical effect of the other users in a network. Network externalities, however, often occur through more subtle means. Consider competition among producers of computer hardware. Here, the situation is more complicated because there is interaction between producers of hardware and producers of software. Loosely speaking, users must really choose two complimentary networks, or there are two sides to each network.

Most consumers are faced with a choice between buying an Apple or a Windows/Intel system. If the network of Windows/Intel computer users is larger, then there is more incentive for software producers to make Windows software. This effect results in a network externality: the consumers value a particular piece of hardware more if the brand's user network is larger. For instance, a high school student crazy about computer gaming might pick an Intel machine over an equivalent Apple machine simply because she will have a wider choice of video games.

In this case, the network externality leads to a positive feedback system yet again. Every additional consumer of Intel hardware contributes to the demand for Intel-compatible software, thus promoting even more software development for the dominant system. A greater variety of software, in turn, increases the value of each Intel computer system, and more consumers buy one, joining the network, and contributing to the Winner-Take-All effect.

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