DP3738 Indirect Network Effects and Adoption Externalities

Author(s): Jeffrey Church, Neil Gandal, David Krause
Publication Date: February 2003
Keyword(s): network effects, network externalities
JEL(s): L13
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3738

The conventional wisdom is that indirect network effects, unlike direct network effects, do not give rise to externalities. In this Paper we show that under very general conditions, indirect network effects lead to adoption externalities. In particular we show that in markets where consumption benefits arise from hardware/software systems, adoption externalities will occur when there are (i) increasing returns to scale in the production of software, (ii) free-entry in software, and (iii) consumers have a preference for software variety. The private benefit of the marginal hardware purchaser is less than the social benefit since the marginal hardware purchaser does not internalize the welfare improving response of the software industry, particularly the increase in software variety, on inframarginal purchasers when the market for hardware expands.