Network Externalities and the Battle between Microsoft and Apple: Many markets related to technology products operate in the presence of network externalities because the value of such products to consumers depends on how many other consumers are in the “network” of consumers. For instance, an internet connection would not be nearly as useful if no one else in the world was connected to the internet; a telephone becomes more useful the more other people also have telephones; and a computer operating system becomes more useful the more others use it — because then the market for software that runs on this operating system increases which in turn fosters greater software innovation for that platform. Assume throughout that we are analyzing the consumer market for computers and that a consumer buys at most one computer.
A. Consider the market for PC’s when the Microsoft Windows system first competed with the Apple Macintosh platform in the 1980’s. Microsoft and Apple pursued very different strategies: Microsoft licensed the Windows plat form to lots of PC makers who competed with one another and thus drove down the price of PCs. Apple, on the other hand, did not license its Macintosh operating system— and sold it only with its own Apple computers that were more expensive.
(a) Suppose that people vary greatly in their interest for buying a personal computer, but their willingness to pay for a computer increases with the square root of the size of the “network” of others who use a computer with the same operating system; i.e. if someone’s willingness to pay for a computer is B when no one else is in the “network”, her willingness to pay for the same computer is BN1/2 when the network has N people. Pick three different levels of N — with N1 < N2 < N3 — and illustrate the linear aggregate demand curves— D1, D2 and D2 —that correspond to these levels of N for a computer with a particular operating system.
(b) Suppose the demand curve D1 tells us that N1 computers are demanded at price p. In what sense is this equilibrium in which consumers are taking into account the network externality in their decision-making?
(c) Now suppose the price drops from p to p′. If everyone assumes that the network size remains fixed at N1, illustrate how many more computers will be sold. Why can this not be an equilibrium in the same way that our previous situation was an equilibrium?
(d) Now take into account that people will realize that the network is growing as price falls. What will happen if the number of computers demanded at p′ on D3 is N3? Illustrate the new equilibrium—and explain why some economists say that network externalities give rise to a bandwagon effect in addition to a direct price effect.
(e) How do you think the process of moving from our initial equilibrium to the final equilibrium unfolds over time as price falls from p to p′? True or False: Network externality of this kind cause demand to become more price elastic.
(f) Microsoft got a head start with its licensing policy that created competition and thus sharply falling prices in the PC market—while Apple’s computers were perpetually priced above PC’s. Can you use this model to explain how Microsoft’s Windows operating system became the dominant operating system?
(g) Suppose that the quality of Apple computers is now far better than any competing PC’s—and that it can be priced competitively. Why is this not enough for Apple to gain dominance in the computer market? How might you argue that the network externality you analyzed has led to an inefficient market outcome?
Answer: Even if Apple computers have a far superior operating system now — and even if
(h) Explain the following statement made by a technology company executive: “In the quickly moving tech market, it is usually better to be first rather than best.”
(i) In a recent update to its operating system, Apple introduced a new feature that allows users to switch between the traditional Macintosh operating system and the Microsoft Windows operating system. Do you think this was a good move in light of what this exercise has told us about network externalities?
B. Now considers the type of network externality described in part A more carefully. Suppose that the aggregate demand function for computers is given by x = (AN1/2 −p)/α.
(a) Does this demand function give rise to the parallel demand curves (for different levels of network size) you analyzed in part A?
(b) The consumer side of the market is in equilibrium if the network size N is equal to the number of computers sold. Use this to derive the actual demand curve P(x) that takes the network externality fully into account.
(c) Suppose A > 2α. What is the shape of this demand curve? Explain.
(d) Check your answer to (c) by graphing the demand function when A= 100 and α = 1. Continue with these parameter values for the rest of the exercise.
(e) In models like this, we say that equilibrium is stable if it does not lie on an upward sloping portion of the demand curve. Can you guess why? (Hint: Suppose that x∗ is the equilibrium quantity on the upward sloping part of demand for some price p∗. Imagine what would happen if slightly more than x∗ were bought, and what would happen if slightly less than x∗ would be bought.)
(f) Suppose the supply curve is horizontal at p = 2,000. Our model implies there are three equilibria — 2 that are stable and one that is not stable. What network sizes are associated with each of these equilibria?
(g) Suppose that we begin in the equilibrium in which no one owns a computer and the marginal cost of producing computers is $2,000. Why might firms launch an aggressive campaign in which they give away computers before selling them in stores? How many might they give away to “jump-start” the market?