Regulation by Networks

The private ordering literature examines how nongovernment institutions mitigate opportunistic behavior in transactions. It emphasizes two elements that facilitate cooperation and reduce opportunism: repeated play and reputation. This paper explores the implications of a third element: network effects. Network effects create an incentive for a unique form of opportunism that exists only in network environments - degradation. On the other hand, network effects facilitate mechanisms that may be very effective in mitigating opportunism. Therefore, in certain industries, networks mitigate opportunism, largely displacing in that role the parties to the transaction and the government. This paper identifies mechanisms used by networks to reduce opportunism, and market characteristics that are conducive to the effectiveness of these mechanisms (and therefore to the efficiency of networks as regulators). This helps explain the prevalence of networks in certain markets as compared to others, and gives tools to assess networks' ability to self-regulate and anticipate the type of opportunism that is more likely to plague a given environment.