The Lexicon of Networking Economics

Economics rarely improves with reference to etymology, but an exception should be made for the economics of networks. Many valid but distinct definitions of “network economics” compete for attention. That causes confusion in academic writing and in public discourse.

There are many symptoms of this confusion. Consider this one. When the late Senator Ted Stevens inarticulately referred to the Internet as a “series of tubes” it earned him derision from younger denizens of the Internet. To many youngsters it was unthinkable that the ranking Senator on the committee for regulating Internet commerce conflated the physical network – local area networks, backbone lines, access lines – with its applications – email, web surfing, electronic commerce.

To be fair to Senator Stevens, however, such a conflation is rather understandable. Stevens used a habit of mind common in monopoly provision of local electricity and telephony. It came into conflict with another and newer habit of mind, one that lives online. Only recently have these twains begun to meet regularly.

How did this happen? In brief, public discourse typically uses three distinct economic meanings for the term “network” and, without making due distinction, applies these to the same situations.  Let’s  get straight on the meaning of words. This post explains the lexicon of networking economics.

What Ted said

Let’s start with Ted’s quote.

The excerpt from Senator Ted Stevens’ speech — about the series of tubes — first came to the attention of Ryan Singel of Wired when it appeared in the context of this longer soliloquy:

“They want to deliver vast amounts of information over the internet. And again, the internet is not something you just dump something on. It’s not a truck. It’s a series of tubes. And if you don’t understand those tubes can be filled and if they are filled, when you put your message in, it gets in line and its going to be delayed by anyone that puts into that tube enormous amounts of material, enormous amounts of material.”

For a longer explanation, see Wired magazine blog 27B Stroke 6 “Your own Personal Internet,” . As is well known, after that quote, well, one thing led to another, and the blogosphere exploded with commentary.

What went into this confusion?

Consider first the meaning of networks in regulatory economics for utilities.

Three decades ago it was economic canon that the biggest networks in the industrialized world – the telephone, electrical, and gas pipeline networks – shared similar economic determinants. Operators of the networks incurred high fixed costs from large capital expenditures. Delivering services to homes and businesses fostered monopoly provision.

Local, state and federal regulators intervened in operations, implementing mandates governing various aspects of quality and pricing to end users. Regulators also implemented interconnection agreements between networks, and between competitors and monopolists with vertical control over key facilities. Vigorous academic debates considered the myriad approaches to such mandates, while undergraduate textbooks characterized the canon of these debates.

Change came to the canon in several different guises.

One change to the canon came in the guise of new network engineering. Computing network engineers began to hypothesize that industry wide scale economies could arise from sharing expensive immobile or rare resources. In the 1970s experiments with “inter-networking” between computing systems – what we today call the Internet – began to bear fruit. These experiments eliminated redundancies, permitting data shared in one location to travel to many users in distinct locations.

Creating a technology that eliminated such redundancies was one of several key motivations for DARPA to fund the initial experiments that led to the Internet, as it was for the NSF to continue sponsoring its development. For example, there is considerable military value in keeping data stored in a safe place, but accessible by commanders in dangerous locations.

Among its other accomplishments, quite unexpectedly (to the designers) these data systems also fostered new applications and new modes of communication. Today we recognize these as electronic mail, text messaging, Web browsing, and peer-to-peer applications.

Another change to the canon came in a very different guise. It arrived in the confluence of some unlikely market bedfellows. The markets for personal computers, the VCR, high-fidelity stereo systems, and costumer premise telephone equipment seemed to share similar traits. In each case users employed a system of components. The components were complements in demand, but the same firm did not necessarily supply the entire package. Instead, (speaking loosely) multiple firms used similar technical standards to make their components work together.

The competitive interplay between the firms did not fall into existing canon, and raised new questions. Another meaning for network began to resonate in these situations, where “networks” refer to a group of suppliers whose economic fortunes are linked to one another, both as complements and as competitors. It is still quite common today for analysts to refer to a network of suppliers, where these suppliers provide complementary components.

An additional meaning of network also emerged, starting initially in academic discourse, and has persisted to the present. This meaning stressed the role of network effects.

A network effect arises when the value to an individual from using a service rises with increasing participation by others. One source of network effect is a demand-side positive externality, as when a new product or service becomes more valuable as the number of users grow, and adoption of one user is independent of another. These externalities were hypothesized to be common in communications services. Sometimes this is stated in the other direction, as well, that a service is not valuable unless others use it too.

The failure of AT&T’s video phone service in the 1970s initially inspired new thinking by Jeffrey Rohlfs about their effects. AT&T’s service in the early 1970s was a large scale and widely publicized failure, and generated almost no adoption. Examining the failure at the time, economist Rohlfs asserted that the value of the communication network was rising in participation. From this Rohlfs inferred that it had to clear a “minimal size” to create enough value to users to overcome the user-costs of adoption.

Today there is, of course, an enormous theoretical literature on various forms of network effects. Many examples have come to light, and these examples go well beyond the video phone. For example, instant messaging networks invariably require users to all employ the same software to communicate, exhibiting characteristics of network effects. For many of the same reasons, it is common to assert, somewhat casually, that modern social networking sites, such as Facebook, contain a similar element.

Where we ended up

Not surprisingly, confusion arises because many of the markets in which network effects arise are also the markets in which the other meanings of network also arise.

Indeed, the confusion is most pronounced in the area in which Senator Stevens made his statement, the modern commercial Internet. In the Internet today a network of suppliers – i.e., in the sense of complementary and competing component providers – make a system available to users. Some of this activity uses components from telephone firms, including their network trunk lines (which are easily compared to pipe), and parts of these operations must conform to regulatory mandates. Many of the commercial Internet’s most widely used applications – electronic mail, instant messaging and social networking – have been adopted by users who communicate with others, giving rise to network effect.

A non-expert could be excused for not being able to keep these meanings straight, for giving up altogether, or, at least not knowing where to start.

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