DP3738 Indirect Network Effects and Adoption Externalities

Author(s): Jeffrey Church , Neil Gandal , David Krause

Publication Date: February 2003

Keyword(s): network externalities , network effects

JEL(s): L13

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP3738.asp

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.