Indirect network effects
The proliferation of trade liberalization through both economic integration (e.g., the European Union) and preferential trade agreements (e.g., NAFTA) has spawned a vast literature on the implications of trade liberalization. Since liberalization often provides an opportunity to acquire varieties of products not available from domestic producers, welfare gains via increased product diversification are emphasized in the literature.2 As yet, however, the cases of “hardware/ software” systems (i.e., hardware devices and the varieties of complementary software products) are downplayed in the trade literature. In other words, little attention has been paid to the implications of trade liberalization in the presence of products with indirect network effects. Indirect network effects exist when the utility of consumers is increasing in the variety of complementary products available for an electronic hardware device. Examples of such devices include personal computers, video cassette recorders, and consumer electronics products. In systems that pair hardware with software, an indirect network effect arises because increases in the number of users of hardware increase the demand for compatible software and hence the supply of software varieties. Since larger and more integrated markets often provide greater product variation, these characteristics affect the degree to which indirect network effects work. Despite the fact that many industries have indirect network effects that are supported by trade liberalization, the literature on indirect network effects is almost exclusively focused on a closed economy.3 Because the role of indirect network effects is amplified in the globalized world, it seems important to explore the impact of trade liberalization in the presence of products with indirect network effects.4 As our primary contribution, we examine how trade liberalization affects production structure in the presence of indirect network effects. For these purposes we construct a simple, two-country model of trade with two incompatible hardware technologies which is an extension of Church and Gandal’s (1992) closed economy model. We modify their approach to include aspects of trading economies such as intra-industry trade flow of complementary software products and gains/losses from trade. It is shown that, given that two incompatible hardware
devices exist before trade liberalization, trade liberalization may reduce the variety of hardware devices. It is also shown that, if the variety of hardware devices is reduced by trade liberalization, some consumers are made worse off by trade. The current analysis intends to explain the recent situations where increased intra-industry trade of software products and intensified competition among incompatible systems (e.g., Blu-Ray Discs and HD DVD) may leave some early adopters stranded with abandoned incompatible equipment.5 It is important to note that the result that some consumers are made worse off by trade is not new in trade literature, as Heckscher-Ohlin and other competitive models show.6 However, our results are derived from a non-competitive and increased intra-industry trade setting, which usually emphasizes mutual gains via intra-industry trade. It is also important to note that we are using a Nash equilibrium concept, in which equilibrium outcomes are typically Pareto inefficient: this point is emphasized in duopoly trade models.7 However, this point is also downplayed in an intra-indutry trade setting. The main result of the current study, which illustrates the possibility of loss from trade via increased intraindustry trade, has not appeared in the existing trade literature. This chapter is organized as follows. Section 13.2 describes both consumer preferences and technologies. Section 13.3 describes the basic model and derives an autarky equilibrium. Section 13.4 considers the impact of trade liberalization. Section 13.5 offers concluding remarks.