Network Externalities, Competition, and Trade: East Asian Perspectives

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1 Ntwork Extrnalitis, Comptition, and Trad: East Asian Prspctivs Toru Kikuchi 1 and Chiharu Kobayashi Abstract Thr ar larg dviations in accss to tlcommunications infrastructur and trading pattrns within th East Asian rgion. W xamin how th ntwork xtrnalitis of communication activitis and trading opportunitis intract to dtrmin th structur of comparativ advantag. Ths intractions ar xamind by constructing a simpl two-country, two-good modl of trad involving a country-spcific communications ntwork sctor. Th rol of comptition of ntwork srvic providrs, which allows usrs of a ntwork asir accss to othr ntworks, is also xplord. (JEL Classification: D43, F12, L13) 1. Introduction As conomic intgration in East Asia progrsss, trad pattrns within th rgion ar displaying an vr-gratr complxity: Though intra-industry trad is growing in importanc, th shar of intr-industry trad still accounts for majority. In othr words, trad and production structurs vary widly within East Asian countris. 2 Rlatd to such phnomna, it is widly rcognizd that th growing connctivity of individuals and organizations achivd through nw typs of communications ntworks (.g., th Intrnt 1 W would lik to thank Michal Gilroy, Masami Imai, Fukunari Kimura, Tako Nakao, Elaina Ros, Kang Shi, Ryuhi Wakasugi and th participants of Kora and th World Economy IV confrnc for thir kind suggstions. This papr has also bnfitd from commnts by th ditor and two anonymous rfrs. Th first author is gratful for financial support providd to th 21st Cntury Cntr of Excllnc Projct by MEXT (Ministry of Education, Cultur, Sports, Scinc and Tchnology). Th scond author is gratful for financial support providd to Acadmic Frontir Projct, , by MEXT. 2 In this rspct, Fukao t al. (2003, pp ) conclud that, in East Asia, thr xist much highr barrirs against intra-rgional trad and FDI than in othr rgions (.g., EU), which ar likly to rduc intra-industry trad. Thy also suggst that thr is a high incom gap among East Asian countris, which is likly to rduc horizontal spcialization bcaus of th diffrncs in th industrial structur and prfrncs. 1

2 and satllit communications ntworks) and a consqunt incras in th information flow play an important rol as a dtrminant of trad structurs. 3 East Asian countris hav bcom incrasingly awar that both th quality and th scal of thir communications infrastructur hav bcom crucial factors dtrmining thir comparativ advantag. 4 Thr ar larg dviations in dvlopmnt lvls of tlcommunications infrastructur and computr tchnology within East Asian countris. Thr ar svral rasons for ths dviations, such as lack of infrastructur. Th cost of using tlcommunications and accssing th Intrnt is on of th most obvious barrirs. Rlatd to this, Hargittai s (1999) analysis of Intrnt connctivity concluds that th rgulatory nvironmnt and its influnc on comptition hav th largst impact on Intrnt pntration that is, th comptition btwn tlcom srvic providrs incrass Intrnt connctivity. Thus, w can say that comptition btwn srvic providrs is a ky fatur of communications ntworks. Th worldwid trnd toward drgulation and privatization in tlcommunications bgan in th 1980s and acclratd in th 1990s. Until lat in th 1990s, howvr, this trnd laggd in East Asian countris. In 2000, only half of th tlcommunications oprators in th Asia-Pacific rgion wr privatly ownd, compard with 63% in Europ and 74% in th Amricas. 5 Furthrmor, just undr 40% of local tlphon srvic providrs in th rgion xprincd any comptition. Howvr, in rcnt yars, East Asian countris hav undrgon dramatic rgulatory and policy changs, including introducing comptition into th sctor, stablishing a sparat rgulatory agncy and privatizing incumbnt carrirs (Tabl 1). Tabl 1: Lvl of Comptition in Slctd East Asian Economis For Slctd Tlcommunication Srvics, 2004 Economy Local Srvics Int l Sparat Rgulator Status of Main Fixd-Lin Oprator China Partial Partial No Stat-Ownd and Partially Privatizd Hong Kong Ys Ys Ys Privatizd Indonsia Partial Partial Ys Partially Privatizd Japan Ys Ys No Fully Privatizd Kora Ys Ys Ys Fully Privatizd 3 S Cairncross (1997), Sidornko and Findlay (2001). 4 According to this lin, Matoo t al. (2001) find that countris with th fully libralizd tlcommunications sctor can grow up to 1.5% pr yar fastr than thos with mor rstrictiv policis. S, also, Li and Xu (2002). 5 S, ITU (2000). According to this, Yusuf and Evntt (2002, ch. 5) conclud that East Asia still has much catching up to do. 2

3 Philippins Ys Ys Ys Fully Privatizd Singapor Ys Ys Ys Partially Privatizd Taiwan Ys Ys No Partially Privatizd Sourc: ITU (2004) Thr is anothr ky fatur of communications ntwork : th xistnc of strong ntwork xtrnalitis. Ntwork xtrnalitis occur if th valu of th good (or th srvic) to a usr dpnds on th numbr of usrs using th sam or similar good (srvic). 6 Although ntwork xtrnalitis ar oftn rgardd as consumption xtrnalitis, rcnt litratur on communications ntworks mphasizs th rol of ntwork xtrnalitis in th production sctors: du to an incrasd information flow, ach workr s productivity dpnds on th siz of th ntwork. 7 Givn that thr ar strong ntwork xtrnalitis in th production sctors, it is important to captur a crtain numbr of usrs to attain a favorabl siz of ntworks. In othr words, th siz of on country s ntwork plays an important rol as a dtrminant of trad structurs. Th world s broadband succss storis, such as on in Kora, shar such ky factors (.g., pro-comptitiv tlcommunications policis and rgulations, spcial incntivs for th provision of broadband to rural aras and thos population groups with lss attractiv conomic charactristics, and so on). Th sminal contribution to mphasizing th importanc of comptition btwn srvic providrs (and ntwork xtrnalitis) is Katz and Shapiro (1985). 8 Howvr, as thir modl is basd on a singl (or closd) markt for on consumption good, th rol of comptition btwn providrs as a dtrminant of comparativ advantag is downplayd in th analysis. Sinc th rol of comptition btwn domstic srvic providrs is mphasizd in th globalizd world, it sms important to xplor th rols of both (a) ntwork xtrnalitis in production and (b) comptition btwn srvic providrs in th trading-conomis stting. As its primary contribution, w xamin how th ntwork xtrnalitis of communication activitis, comptition btwn srvic providrs, and trading opportunitis intract to dtrmin th structur of comparativ advantag btwn countris, which also 6 Thr is an important concpt rlatd to ntwork xtrnalitis intrconnctivity which allows usrs of a ntwork to communicat with usrs of othr ntworks. Crmr t al. (2000) xplor th rol of intrconnctivity btwn Intrnt Srvic Providrs (ISPs) in th closd conomy stting. Kikuchi (2003, 2004) xplors th rol of intrconnctivity using a monopolistically comptitiv trad modl. 7 For xampl, David (2000) argus that th dvlopmnt of Intrnt tchnology has opnd th door to an ntirly nw class of organization-wid data-procssing applications and has standardizd th potntial for collctiv and cooprativ forms of work organization. Also, h has mphasizd th rol of ntwork xtrnalitis in th production sctors. 8 S Katz and Shapiro (1994), Economids (1996), Shy (2001) for survys of th rlvant litratur. Libowitz and Margolis (1994) distinguish btwn ntwork ffcts and ntwork xtrnalitis, qustioning th validity of th lattr concpt. 3

4 hlps to undrstand th rol of communications ntworks in East Asian trad pattrns. For ths purposs w construct a simpl two-country, two-good modl of trad with country-spcific communications ntworks. It will b shown that a comparativ advantag in th good that rquirs ntwork srvics is hld by th country with comptitiv srvic providrs (i.., a largr numbr of providrs). It is also mphasizd that, givn that thr ar strong ntwork xtrnalitis, diffrncs in comptitiv nvironmnt of srvic providrs work as a catalyst for intrnational spcialization. In othr words, thr is a circular procss btwn ntwork xpansion and trad cration. In th nxt sction w prsnt th basic modl. Th rol of comptition btwn ntwork srvic providrs as a dtrminant of trad pattrns is considrd in Sction 3, followd by concluding rmarks prsntd in Sction Th Modl Considr a world conomy consisting of two countris, Hom and Forign. 9 Thr ar two goods: a primary commodity which is producd only by labor and a high-tch product which is producd with both labor and communications srvics. Communications srvics ar assumd to b providd by country-spcific ntwork srvic providrs. Thr ar n (n*) idntical providrs in Hom (Forign): 10 thy ar playing a Cournot comptition. Providrs will b indxd by labl i (i = 1,..., n). Lt x i dnot th siz of th i-th providr (i.., th numbr of subscribrs), y i th siz of th ntwork with which th i-th providr is associatd, and lt z b th total numbr of ntwork usrs. For xampl, whn n providrs ar fully intrconnctd, z = y i = x x n holds. Lt th high-tch product b th numrair and p indicat th rlativ pric of th primary good. Th primary good is producd undr constant rturns tchnology; units ar chosn such that its unit input cofficint is unity. Each country is populatd by a continuum of workrs with population L. Each workr is ndowd with on unit of labor and som lvl of human capital for th production of th high-tch product, which is masurd by indx r. r is uniformly distributd ovr th intrval [0, L]. Each workr s productivity is also affctd by th lvl of ntwork xtrnalitis, vy i, whr v (v 1) is a valuation paramtr and i y is th workr s xpctation of th siz of th (i-th) ntwork. Th v trm capturs gains through incrasd information flow btwn individuals: if mor workrs join th communications 9 Th structur of this modl is basd on Kikuchi (2005) which mphasizs th rol of intrconnctivity as a dtrminant of trad pattrns. Howvr, in this papr, w mphasiz th rol of comptitiv nvironmnt of srvic providrs as a dtrminant of trad pattrns. 10 To kp mattrs simpl, w assum that th numbr of providrs is xognously dtrmind. Govrnmnt rgulation could b a major factor. Diffrncs in th lvl of ntry fixd cost could also b an important factor. Ths kinds of xtnsion nd furthr considration. 4

5 ntwork, ach workr can collct information mor fficintly. It is simply assumd that a typ-r workr can produc r + vy i units of th high-tch product. Workrs hav th choic of ithr supplying labor for th production of th primary good or bcoming a supplir of th high-tch product, and workrs will bcom th lattr only if thy connct to a communications ntwork. To connct to th i-th providr s ntwork, ach workr must pay a connction f, f i, in xchang for unlimitd accss up to th maximum throughput of thir particular connction. A typ-r workr chooss to connct to th ntwork for which r + vy ( f p) (1) i i + is largst. This can b intrprtd as follows. If r + vyi fi p holds for a particular workr, that workr pays th connction f and starts to produc th high-tch product. Howvr, if r + vyi fi < p holds, that workr chooss not to connct to th ntwork and producs th primary good instad. As p riss, mor workrs choos not to connct to th ntwork. Thus, on can intrprt (f i + p) as a connction f including th outsid option. In quilibrium, providrs i and j will both hav a positiv numbr of subscribrs only if ( f + p) vy = ( f + p) vy, (2) i i j j whr ( fi + p) vy i is th connction cost adjustd for ntwork siz. 11 Lt Φ dnot th common valu of this cost. For a givn valu of Φ, only thos workrs for whom r > Φ bcom producrs of th ntwork good. Givn th uniform distribution of r, thr ar L Φ workrs who choos to connct to th ntworks. Thus, if th total numbr of ntwork usrs is z, z = L Φ holds. Thn, by substituting Φ = ( fi + p) vy i into this, w obtain th condition for th connction f f i = L p + vy z. (3) i To simplify th analysis, w assum that th production cost for ach providr is qual to zro. Thus th i-th providr s profits ar π i = x i f i = x i (L p + vy z). (4) i Now considr th quilibrium supply lvl of th high-tch product. By Equations (1) and (3), a typ-r workr can produc r + z + f + p L units of product. Furthrmor, 11 (2) implis that all th xisting ntworks in quilibrium provid ncssarily th sam surplus, which is dfind as (1). 5

6 only thos workrs for whom r is gratr than L z join th ntwork, whil th othrs choos to produc th primary good. Intgrating all workrs who do connct to th ntworks, w can obtain th total output of th high-tch product: L 2 S( z) = ( ρ + z + f + p L) dρ = ( z / 2) + ( f + p) z. (5) L z W can intrprt this as th supply function of th high-tch product. This function is rprsntd by OS in Figur 1(b). As th total numbr of ntwork usrs bcoms largr, th avrag productivity of ach high-tch product supplir riss (this is shown as lins OA and OA in Figur 1(b)). Th conomy thus has a supply function that xhibits incrasing rturns to th siz of th ntworks. Mor notworthy is that, in trms of incom inquality btwn sctors, as th siz of th ntworks bcoms largr, incom inquality btwn sctors incrass. 6

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8 Dpnding on th intrconnctivity btwn providrs, svral cass can mrg as th production quilibrium. For simplicity, lt us assum that n providrs ar fully intrconnctd (i.., y i = x x n =z). 12 A usr who conncts to on ntwork can communicat with usrs of othr ntworks. Intrconnctivity xpands th siz of ach ntwork to th total mmbrship of all providrs. This raiss th productivity gains njoyd by a workr who subscribs to only on providr s ntwork bcaus ntwork xtrnalitis dpnd on th total siz of th ntwork. Thus, maximizing (4) with rspct to x i, w obtain xi = L p + vz z. Imposing th rquirmnt that in quilibrium workrs xpctations ar fulfilld (Fulfilld Expctation Equilibrium), z = z = nx holds. Thn w obtain th quilibrium sals lvl for ach providr x = (L p)/(n + 1 nv). (6) By summing Equation (6) ovr all providrs, w obtain th total ntwork as a function of th rlativ pric of th high-tch product (1/p). z(1/p) = [n(l p)]/(n + 1 nv). (7) Th quilibrium is dpictd in Figur 1(a). Th horizontal axis shows th total siz of th ntwork, z, whil th vrtical axis shows th valus of L p+vz and [(n + 1)z]/n. Equilibrium is obtaind at an intrsction of two curvs: Lin ON rprsnts [(n+1)z]/n whil th othr lin rprsnts L p+vz. As p bcoms smallr, th lin will shift upward, which rsults in a largr total siz of th ntwork. Now turn to th impact of an incrasd comptition btwn providrs. An incras in th numbr of srvic providrs can b shown as a clockwis shift of lin ON (.g., ON ), which also rsults in a largr siz of th ntwork. As th total numbr of ntwork usrs bcoms largr, th avrag productivity of ach workr in th high-tch product sctor riss. Thr ar two sourcs of ths gains: (1) as th markt of ntwork srvics bcoms mor comptitiv, ach providr chooss to st a lowr connction f, which attracts mor workrs and (2) as mor workrs join th ntworks and th total numbr of subscribrs incrass, ach infra-marginal workr can attain highr productivity. 3. Comptition btwn Providrs and th Impact of Trad Intgration 12 As spac is limitd, w concntrat on th natur of th quilibrium and pay scant attntion to th factors that dtrmin intrconnctivity. 8

9 Suppos that th only diffrnc btwn two countris is th numbr of ntwork srvic providrs. Without loss of gnrality, Hom is assumd to hav mor providrs than Forign (i.., n > n*). Not that an incras in th numbr of providrs shifts th supply curv of th high-tch product to th right (Figur 2). Also, lt ach country hav th sam dmand function for th high-tch product, D(1/p), which is shown as a downward sloping curv in Figur In this cas, from Figur 2, Hom has th lowr autarky pric of th high-tch product (i.., (1/p) < (1/p*)). Now suppos that two countris (Hom and Forign) opn thir goods markts and 13 Not that w assum away any incom ffct. 9

10 hav a trad rlationship. Th opning of trad provids an opportunity for ntry into Hom s high-tch product sctor bcaus, with xpandd ntwork siz, th avrag productivity of Hom workrs is much highr than that of Forign workrs. On th othr hand, marginal workrs in Forign s high-tch product sctor stop producing th high-tch product du to th rducd rlativ pric. Thus th siz of Hom ntworks with comptitiv providrs will xpand, whil Forign ons with lss comptitiv providrs contract. Th diffrncs in th ntwork sizs will b rinforcd by this ntry-xit procss. That is, thr will b a cumulativ procss in which trading opportunitis bring an opportunity for largr ntworks, and th incrasd sizs of th ntworks promot (through intnsifid ntwork xtrnalitis) xports. This procss will continu until th pric diffrntial btwn countris disappars ((1/p T ) in Figur 2). Suprscript T indicats th trading quilibrium valu. Proposition 1: A comparativ advantag in th high-tch product is hld by a country with comptitiv srvic providrs. If th two countris commnc fr trad from autarky, th country with mor comptitiv providrs incompltly spcializs in th high-tch product and th country with lss comptitiv providrs incompltly spcializs in th primary good. [Proof] In th trading quilibrium, th following conditions must b hld: S(z(1/p T )) > S*(z*(1/p T )) and D (1/p T ) =D* (1/p T ). This implis that, du to intnsifid ntwork xtrnalitis, Hom bcoms an xportr of th high-tch product: S(z(1/p T )) - D (1/p T ) > 0. (Q. E. D.) Proposition 1 implis, givn that thr ar strong ntwork xtrnalitis, diffrncs in th numbr of srvic providrs (i.., th lvl of comptition) rsult in a larg variation in spcialization pattrns. This may hlp to xplain larg dviation in both th dvlopmnt of communications infrastructur and trading pattrns within th East Asian rgion. This proposition also mphasizs th importanc of comptition policy for th domstic communications sctor to surviv in th globalizd world conomy. Sinc th siz diffrntial btwn country-spcific ntworks is magnifid through intrnational trad, w also obtain th following proposition. Proposition 2: Opning intrnational trad incrass inquality in th country that xports th high-tch product and rducs inquality in th country that xports th primary good. [Proof] Sinc (1/p) < (1/p T ) < (1/p*) holds, th siz of th country-spcific ntwork changs as follows: z(1/p T ) > z(1/p) and z*(1/p T ) < z*(1/p*). This implis that Hom s incom inquality bcoms gratr whil Forign s bcoms smallr. (Q.E.D.) 10

11 4. Concluding Rmarks In this study, w xamin how th ntwork xtrnalitis of communication activitis, comptition btwn srvic providrs, and trading opportunitis intract to dtrmin th structur of comparativ advantag btwn countris, which also hlps to undrstand th rol of communications ntworks in East Asian trad pattrns. It should b mphasizd that diffrncs in comptitiv conditions among country-spcific ntwork srvic providrs dtrmin th comparativ advantags of countris: although ach country is ndowd with qual amount of labor, th country with comptitiv providrs can attain highr productivity through incrasd information flow. Mor notworthy is that thr is a circular procss btwn ntwork xpansion and trad cration which furthr affcts incom inqualitis within ach country. Although ths rsults ar drivd undr th assumption that communications ntworks ar purly country-spcific, it appars that somthing similar to this will occur in mor gnral sttings. Th prsnt analysis must b rgardd as vry tntativ. Hopfully it provids a usful paradigm for considring how communications infrastructur works as a driving forc for th dvlopmnt of th East Asian rgion. Rfrncs [1] Cairncross, F. Th Dath of Distanc, Boston, Mass.: Harvard Businss School Prss, [2] Crmr, J., P. Ry, and J. Tirol. Connctivity in th Commrcial Intrnt, Journal of Industrial Economics, 48, 2000, pp [3] David, P. A. Undrstanding Digital Tchnology s Evolution and th Path of Masurd Productivity Growth, in Undrstanding th Digital Economy, ditd by E. Brynjolfsson and B. Kahin. Cambridg, Mass.: MIT Prss, 2000, pp [4] Economids, N. Th Economics of Ntworks, Intrnational Journal of Industrial Organization, 14, 1996, pp [5] Fukao, K., H. Ishido, and K. Ito. Vrtical Intra-Industry Trad and Forign Dirct Invstmnt in East Asia, Journal of th Japans and Intrnational Economis, 17, 2003, pp [6] Hargittai, E. Waving th Wstrn Wb: Explaining Diffrncs in Intrnt Connctivity among OECD Countris, Tlcommunications Policy, 23, 1999, pp

12 [7] ITU (Intrnational Tlcommunications Union). Asia-Pacific Tlcommunications Indicators 2000, Gnva, [8] ITU (Intrnational Tlcommunications Union). Asia-Pacific Tlcommunications Indicators 2004, Gnva, [9] Katz, M. L., and C. Shapiro. Ntwork Extrnalitis, Comptition, and Compatibility, Amrican Economic Rviw, 75, 1985, pp [10] Katz, M. L., and C. Shapiro. Systms Comptition and Ntwork Effcts, Journal of Economic Prspctivs, 8(2), 1994, pp [11] Kikuchi, T. Intrconnctivity of Communications Ntworks and Intrnational Trad, Canadian Journal of Economics, 36, 2003, pp [12] Kikuchi, T. Communications Ntworks and Rgional Economic Dvlopmnt, Th Journal of th Koran Economy, 5 (1), 2004, pp [13] Kikuchi, T. Ntwork Extrnalitis as a Sourc of Comparativ Advantag, Economics Bulltin, 6 (7), 2005, pp [14] Li, W., and L. C. Xu. Th Political Economy of Privatization and Comptition: Cross-Country Evidnc from th Tlcommunications Sctor, Journal of Comparativ Economics, 30, 2002, pp [15] Libowitz, S. J., and S.-E. Margolis. Ntwork Extrnality: An Uncommon Tragdy, Journal of Economic Prspctivs, 8 (2), 1994, pp [16] Matoo, A., R. Rathindran, and A. Subramanian. Masuring Srvics Trad Libralization and Its Impact on Economic Growth: An Illustration, Working Papr 2655, World Bank, Washington D. C., [17] Sidornko, A., and C. Findlay. Th Digital Divid in East Asia, Asian- Pacific Economic Litratur, 15 (2), 2001, pp [18] Shy, O. Th Economics of Ntwork Industris, Cambridg Univrsity Prss, [19] Yusuf, S., and S. J. Evntt. Can East Asia Compt? Innovation for Global Markts, World Bank, Washington D. C.,