Standardization and Network Externalities

Abstract

The standardization issue in the ICT industry is mainly compatibility in the presence of network externalities. The compatibility in Economics usually means interoperability between competing products. For instance, the VHS VCRs and the Betamax VCRs are incompatible in the sense that tapes recorded in one format (e.g., VHS) could not be played in the other format (e.g., Betamax). Hence, in the ICT industry, standardization mainly signifies achieving compatibility. Standards can be achieved by mandatory or voluntary measures as well as by de facto standardization. It is an important policy issue whether the government should mandate a standard (or impose compatibility), let the stakeholders (especially, firms) decide a standard, or enforce sponsoring firms to compete in the market, which has substantial impacts on consumer (or end user) well-being as well as business strategies in R&D, technology sponsorship, and competition in the product market. Ultimately, the impacts of standardization policies should be analyzed in terms of costs and benefits of firms (i.e., profit analysis) and the society (i.e., welfare analysis). In this chapter, we suggest an analytical framework to provide a consistent review of theoretical and empirical models of firms’ and consumers’ (or end users’) incentives and behavior under different standardization policies. The chapter is organized as follows. In section 2, we will discuss the Katz and Shapiro model which analyzes how compatibility (or standardization) affects firms’ optimization behavior in the product market and whether private incentives for compatibility are consistent with the social incentive. Section 3 will shift our focus onto the consumer’s adoption decision of new technology over old technology. We will discuss the pioneering Farrell and Saloner model which studies whether consumers’ adoption decision of incompatible new technology is socially optimal. Then we will proceed to introduce several important extensions of the model. The dynamics of standardization process will be explored in section 4. Based on the empirical study of Park (2004a), the de facto standardization of the VHS format in the U.S. home VCR market will be analyzed and further utilized to understand strategic aspects of standardization. Despite recent economists’ attentions to the issue of standardization and network externalities, the literature itself still lags behind reality. In section 5, we will examine ongoing and future research issues requiring further cost-benefit analyses based on economic models. Section 6 will conclude.