Barriers to Network-Specific Innovation*
By Antoine Martin and Michael J. Orlando
Revised: September 2005
(First Version: November 2004)
RWP 04-11
Research Division
Federal Reserve Bank of Kansas City
Abstract
We examine incentives for network-specific investment and the implications for network governance. We model an environment in which participants making payments over a network can invest in a technology that reduces the marginal cost of using the network. A network effect results in multiple equilibria; either all agents invest and use of the network is high or no agents invest and use of the network is low. The high-use equilibrium can be implemented where commitment is feasible. Where commitment is infeasible, fixed costs associated with use of the network-specific technology result in a hold-up problem that implements the low-investment equilibrium. As a result, governance structures necessary to achieve commitment will be preferred to those necessary merely to achieve coordination. For example, mutual ownership by network users may emerge where users face risks of ex post renegotiation. Such a governance structure will also be sufficient to avoid the network effect.
Keywords: Hold-up, Network; Commitment; Payments
JEL Codes: E59; G29; L14; L22
*This paper circulated previously under the title “Hold-up on a monopoly-owned network,” We thank Matthew Cardillo, Dino Falaschetti, Ed Green, Fumiko Hayashi, Thor Koeppl, Courtney LaFountain, Rody Manueli, James McAndrews, Stacey Schreft, David Skeie, Neil Wallace, Zhu Wang, seminar participants at the Conference on the Economics of Payments (Atlanta 2004), the Missouri Economic Conference (Columbia 2004), the Penn State Macroeconomics seminar series, and The Federal Reserve Bank of Chicago Payment Systems Research seminar series for useful comments. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Kansas City, the Federal Reserve Bank of New York, or the Federal Reserve System.