THE ECONOMICS OF STANDARDS
The economics of standardization largely began with work by David (1985), Farrell and Saloner (1985) and Katz and Shapiro (1985), although Rohlfs anticipated some of the analysis in an article (1974) on telecommunication networks.
Fundamental to this analysis is the concept of network externalities, or network effects, which exist when the value of a product to any user is greater the larger the number of other users of the same product. Direct network externalities exist when an increase in the size of a network increases the number of others with whom one can ‘communicate’ directly. Indirect network externalities exist when an increase in the size of a network expands the range of complementary products available to the members of the network. Both of these are present in the Internet.Where technologies are unsponsored, so that users choose among competing technologies but the suppliers of those technologies either cannot, or choose not to attempt to influence the nature or pace of adoption, several things may occur. First, network effects may outweigh preferences for intrinsic product characteristics so that, although a user would prefer the characteristics of one product to those of another if they were on
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networks of comparable size, he or she may choose to join the larger network in order to obtain its benefits. Second, network industries may exhibit ‘tippiness’, a tendency for a single technology to dominate because, as one network acquires more users, this increases the value of that network to other users, inducing them to join, and so on. Third, when consumers choose sequentially, ‘stranding’ may occur because adopters of a technology that ‘loses’ may either obtain few network benefits or may have to incur the substantial costs of switching to the winning network. Fourth, network industries may exhibit path dependence, so that the behavior of early adopters may have a disproportionate influence on the equilibrium outcome.
Fifth, consumer expectations may be critical to the final equilibrium because users must often choose among technologies before those technologies have reached their ultimate network size. Finally, lock-in may occur on the ‘wrong’ technology because if, for whatever reason, the wrong technology is chosen, it may be difficult to achieve the coordinated movement of large numbers of users required for the ‘right’ technology to become the standard.When sponsors of competing technologies wish to influence the outcome of the standard-setting process, or, more generally, to determine which network ‘wins’, the focus is on the strategies and tactics adopted by sponsors.2 When sponsors decide to engage in a standards ‘battle’ they may attempt to build an early lead by, for example, (1) making the product available to early adopters at low prices, in order to influence the expectations of late adopters; (2) attempting to attract the suppliers of complementary products by, for example, providing information that facilitates the development of compatible products;
(3) pre-announcing products in order to discourage users from joining rival networks;
(4) and/or they may commit to low future prices in order to assure adopters that they will not be stranded on a small network.
It is also important to observe that the winner of a standards ‘battle’ may choose to make it difficult for others to join its network if the benefits to the winner from a somewhat larger network that open membership makes possible are more than offset by the increased competition to which it will then be subject. Among the ways that the winner might deny access to its network are by enforcing intellectual property rights, thus making it illegal for rivals to produce compatible products, changing technology frequently so that rivals are unable to respond quickly enough to offer products that users can employ on the dominant network, and refusing to share information with rivals about changes in network design.
Finally, sponsors may choose not to engage in a standards ‘battle’ but instead they may agree on a standard and agree to low-cost or royalty-free licensing to all of their respective technologies in order to allow the benefits of standardization to be shared among competing firms. They may also agree on standards that combine aspects of their technologies so as to prevent any sponsor from being disadvantaged in future competition.
Whereas the analysis of standardization initially focused on de facto standards, standards that resulted in choices made through the ‘market’, more recent analyses have addressed the behavior of participants in standard-setting organizations (SSOs) where what are sometimes called voluntary standards are established.3 Here, the focus has been on the procedures used by SSOs and on the behavior of their members in attempting to influence the outcome of the standards process.
One concern has been whether the process has been distorted either by strategically placed participants or by the ‘stacking’ of SSO voting. Another has been whether
participants in SSOs have engaged in deceptive practices by, for example, failing to disclose fully their intellectual property rights to other members and attempting to engage in ‘hold-up’, that is, to demand high license fees, after a standard has been widely adopted and industry participants are ‘locked in’. Finally, even where intellectual property rights have been disclosed, there has been considerable controversy about whether intellectual property owners have adhered to SSO policies that, in principle at least, require them to license their technologies on fair, reasonable and non-discriminatory (FRAND) terms, and even on what FRAND means.4 For all of these reasons, standard-setting has increasingly become the subject of antitrust litigation.
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