Network Externality: An Uncommon Tragedy

TLDR

Economists have defined network externality and examined potential inframarginal market failures associated with it. This paper distinguishes network effects from network externalities, identifying the latter as market failures. Network ownership or transactions among participants can internalize some network effects. The authors contend that network externalities are theoretically fragile, empirically undocumented, and largely pecuniary, with the associated market failure being a transition problem rather than a true externality.

Abstract

Economists have defined ‘network externality’ and have examined putative inframarginal market failures associated with it. This paper distinguishes between network effects and network externalities, where the latter are market failures. The authors argue that while network effects are important, network externalities are theoretically fragile and empirically undocumented. Some network externalities are merely pecuniary. Network ownership or transactions among network participants can internalize some network effects. The type of market failure that has been associated with these externalities is a transition problem that has little to do with externality.