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July 7, 2008
Evolving theory of network effects

Should antitrust enforcers be concerned about entry barriers in the search ad market? Some believe the market exhibits "network effects," according to the New York Times.

Although traditionally applied to Industrial Age industries with high fixed costs like railroads and telephone exchanges, anything now exhibits a network effect if its value increases because more people use it. Network effects are "everywhere," according to a top former antitrust official. Coke and Pepsi drinkers, for example, "benefit from the network of their fellow consumers because Coke and Pepsi are widely available in restaurants and in vending machines," claims Timothy J. Muris.

A preexisting network of vending machines is admittedly tough for soft drink imitators to replicate. But a barrier to imitation can also be viewed as a spur to innovation because it acts as a reward which inspires creators and investors. Not an incentive to create a barely distinguishable alternative, to be sure, but to create something transformative.

The alleged network effects in search advertising are more subtle than in the case of railroads, telephone exchanges or soft drinks (in fact, they even bear a striking resemblance to what one might term legitimate and hard-won competitive advantages).

[E]conomists and analysts point out that Google does indeed have network advantages that present formidable obstacles to rivals. The "experience effects," they say, of users and advertisers familiar with Google's services make them less likely to switch. There is, for example, a sizable cottage industry of experts who tailor Web sites to get higher rankings on search engines, which drive user traffic and thus ad revenues. These experts understandably focus their efforts on the market leader, Google -- another network effect, analysts say.
This sounds remarkably like how the European Union sees the market for streaming media players. The EU prohibits Microsoft from including a free player with its PC operating system because its competitors couldn't give away enough copies of their own media players.

Network effect theory overlooks whether, perhaps, there are no other objective differences in the value propositions of the competing products. If consumers have a choice between a superior product versus an inferior product which most of their neighbors are using, the theory assumes most consumers will choose the latter. Thus, there is no incentive for anyone to design a superior streaming media player for a desktop PC.

But that may not be a bad enough thing to warrant letting politicians and bureaucrats rearrange the market. It is inherently destructive to innovation to allow them to do that, because they principally serve constituencies who are more interested in preserving the status quo.

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