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Network Externalities

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Ivan Ivanov Posted: Sat, Nov 3 2007 1:04 PM

 I had a discussion with a friend recently, and somewhere on the way we bumped into the topic of network externalities, and the usual cry of "market failure!" was raised.

From what I've seen so far the usual counter argument is that often the market takes care of the problem itself, and that  this "market failure" is better then anything a government can come up with anyway.

However he had his back covered, as he admitted from the start the there's nothing a government could do to improve things, and he didn't care to argue whether markets can take care of externalities, he just wanted to say that sometimes externalities do happen, and therefore sometimes markets fail.

 So I took a different approach. Ever since I heard of externalities, I had trouble understanding why exactly are they considered to be a bad thing, so I thought that maybe they actually aren't bad.

I mean, when you take network externalities specifically, if someone provides some sort of infrastructure, be it roads, power lines, or operating systems for computers, and someone else comes by and offers a supposedly better infrastructure, the cost of switching to it isn't jut what the price the new provider sets, it's also the cost of replacing everything that needs the old infrastructure in order to work (cars, electric devices, software) in case the old and new systems are incompatible.

For instance, let's say I offered to deliver electricity somewhere in the US for 5% less then the local power company, however I deliver it at 230 Volts instead of the standard 110V. Let's say that if I didn't, power transmission would be less efficient, and I couldn't lower my price.Something like this would render every single electric device in one's household inoperable, so people would no doubt start to wonder if replacing everything is really worth a 5% drop in their electricity bill.

Usually at this point the cries of "market failure" start, because the answer is most likely "no", and so the market insists on using an inferior power network.But if the costs of replacing every single device are actually greater then the benefits of increased efficiency, isn't it actually a good thing that people aren't switching from one network to another? Isn't it a good thing that resources that can be used to create new goods, aren't used to re-create something that already exists, but works with a slightly lower efficiency? Isn't the network externality, much like the often vilified "profit motive", actually an important part of rational allocation of resources?

I never got a reply from my friend, so I thought I'd ask here: do you think I'm on to something, or am I talking nonsense? 

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Who exactly is the market failing -- that's what I would ask.

The consumer who could get access to a more efficient form of electricity but have to shoulder the major burden of the upgrade or the electricity producer who can't profit under the current system.

It would be the same as ethanol producers claiming 'market failure' instead of the competition for resources and high cost of conversion for the ho-hum domestic market for their products. The more oil edges towards $100 a barrel the less the market is failing in this particular case.

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