Network externalities and standardization: a classroom demonstration.

• Author: Ruebeck, Christopher
• Position: Targeting Teaching

1. Introduction

   One challenge many instructors face is that of incorporating the latest economic concepts into lectures when the theory underlying these concepts is more complex than the standard material taught in a principles class. The importance of network externalities in the "information economy" is a timely example. Network externalities exist when the value of a product or service to a consumer depends on how many other people also use the product or service. The externality may be direct--I can send you a fax only if you also have a fax machine--or indirect--the more people who own DVDs, the more movie classics will be put out on DVDs. This classroom game is designed to introduce students to the concepts of network externalities, standardization, and switching costs without requiring any complex mathematical models. In more advanced classes, the game may be followed with an assignment to construct the underlying mathematical model.

   Our game is a straightforward demonstration of how network externalities can lead to the dominance of one technology regardless of its technical superiority over or inferiority to an alternate technology. It focuses solely on the consumer side of the market, with simple setup and execution. (1) In each round there are two competing technologies. The number of students who choose a technology determines the size of that technology's network and the payoff to a student from choosing the technology. In the initial round of the game, students' choices are made simultaneously. In subsequent rounds, the game is changed to introduce sequential decision making, limited information, and switching costs.

2. Conducting the Demonstration

   This game can easily accommodate any number of students, although the effects are more obvious in classes with more than 20 students. In classes larger than about 60 students, you may want to have students work in teams, although any overheard communication is undesirable for reasons described later. Alternatively, in a large class you could have different sets of students participate in different rounds. Depending on the number of participants in each round, you may want to have one or two students act as assistants. Other than copies of the instructions and record sheets, the only materials you need to conduct the demonstration are index cards and envelopes. For each participant (individual or team), you will need two index cards and one envelope per round. (2) Mark the envelopes with the number of the round in which they will be used. Include in each envelope two cards with different symbols, representing the competing choice of technologies in the current round.

   In choosing the technology symbols, it is especially important to be aware of the potential for framing effects (Kahneman and Tversky 1979). If students view one choice as "focal," they will expect others to make that choice. In effect, the participants would be given an indication of the eventual winner. For this reason, any pair of symbols should not provide a focal choice--for example, One versus Two. Likewise, each round's technology symbols should not be related to previous periods' symbols so that prior dominance will not factor into the current choices. We have had success using eight different colors, though we recommend avoiding red. (3) You also should avoid potential framing effects caused by the ordering of the index cards by randomizing which technology is on top in each envelope. It is important to tell students that they are not allowed to talk during the demonstration prior to passing out the envelopes, as any remark could allow students to coordinate on one technology.

   The key characteristic of a market with network externalities is that a consumer's utility depends in part on the size of the network. Let each individual's utility function be [u.sub.i] = x + a * s, where s is the size of the network. The values of x and a that you use will depend on the number of students in the class. A rough rule of thumb is that x/a should be between n/2 and n, where n is the number of participants in each round. This will ensure that the network externalities are large enough to make a difference in utility but not so large that any underlying differences in the technology are irrelevant. Write the utility function on the board or provide students with a utility schedule so that they can calculate their utility for each round of the game.

   Distribute the instructions, record sheets, and envelopes to the students (see Appendices A and B). (4) Each student should have a copy of the instructions, but you need to distribute only one record sheet per team if you are using teams. If all students will participate in each round, distribute the set of envelopes (one for each round) to each participant. If you are having different students participate in each round, distribute one envelope to each student. Read through the beginning of the instructions out loud and have students follow along. Emphasize the importance of students not talking during the game and announce sanctions for talking if necessary.

   Round 1 requires all students to make a simultaneous brand choice, giving them experience with the network externality's effect on utility. Read the instructions for round 1 and give students a minute to make their brand choices. Ask students to hold the index card that they have chosen up to their chest (with the brand choice hidden) to indicate that they have made their choice. Once all choices have been made, ask the students to reveal their choices by turning their cards over and holding them in the air. Have your assistants count the number choosing each brand and post these numbers on the board or on the overhead record sheet provided in Appendix C. Talk through the utility calculations for the...