The Larger the Network Effect

The larger the incentive to surpass the network?

If there is a strong presence of a network effect in an industry along with economies of scale, this industry will tend to only have one or a few providers of a service. If neoclassical monopoly/oligopoly theory is correct, then this company or these companies will earn higher profits than normal. What is not discussed, however, is that these higher profits will serve as an extra incentive for competitors to improve on the existing system and achieve those abnormally high profits themselves. (Note: I think this is a large “if”; there are certainly problems with neoclassical monopoly/oligopoly theory but I am not prepared to defend or attack it on its position that there tend to be higher than normal returns in industries with only a few competitors)

In other words, network externalities (and likely all types of externalities) are self-regulated by the market. If such externalities lead to higher profits, they also lead to a higher incentive for a competitor to attempt to improve beyond the incumbent and make those profits himself.

Any argument advocating government intervention to “fix” the inefficiency that is present with abnormally high profits must acknowledge this market self-regulation and take it into account.

This element of self-regulation might be so great as to reduce the monopoly profits down to normal profits or reduce it by some extent.

Finally: another way of stating the conclusion of this post is that potential competition (that is, competition that is not physically competing, but a force which still exerts some pressure) is stronger in those very sectors where it is often ignored by government apologists.

Photo Credit: brian hefele via Compfight cc


Posted on October 16, 2013, in Economics and tagged , , , , , . Bookmark the permalink. Leave a comment.

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