Stanley M. Besen
Writing in 1950, Harvey Leibenstein analyzed the bandwagon effect, by which he meant the extent to which the demand for a commodity is increased due to the fact that others are also consuming the same commodity. It represents the desire of people to purchase a commodity in order to get into the swim of things; in order to conform with the people they wish to be associated with; in order to be fashionable or stylish; or, in order to appear to be one of the boys.
Leibenstein was not at all specific about the types of goods he had in mind other than to suggest that they were fashion goods. The bandwagon effect remained largely unexplored for another 20 years or so. At that point, economists interested in the development of telephone networks, which clearly are subject to bandwagon effects, began to explore the issue in some detail using modern game-theoretic techniques. For example, Rohlfs observed that The utility that a subscriber derives from a communications service increases as others join the system. This is a classic case of external economies in consumption and has fundamental importance for the economic analysis of the communications industry. Rohlfs then applied this insight in analyzing the origins and development of communications networks.
Except for applications to communications, the analysis of network effects lay largely dormant until the 1980s. At that point, economic historians such as David as well as economic theorists such as Farrell and Saloner and Katz and Shapiro began to explore these issues in the context of the economics of standardization. This stimulated considerable interest in the topic, with the result that literally hundreds of papers devoted to network industries have been published. Moreover, this is a subject to which major contributions have been made by economic theorists, applied economists, economic historians, applied mathematicians, and engineers. Indeed, there now exists a sort of invisible college in which people from a wide variety of disciplines study the subject and attend the same conferences where standards issues are discussed.
For economists, the theory of network effects, or network externalities, or standardization, has wide applicability. Indeed, it has fundamental importance for competition policy, regulation, business strategy, intellectual property, and technical change in a wide range of industries; developments in these industries cannot be fully understood without an understanding of network effects.
Sources of Network Effects
As I have already noted, network externalities exist when the value of a product to any user is greater the larger is the number of other users of the same product. There are basically two ways in which such externalities can occur. 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.
Many industries exhibit network externalities. Some examples are:
What We Think We Know About Network Industries (Unsponsored Technologies)
The study of network industries has yielded important insights, which I briefly summarize here. In this section, I discuss unsponsored technologies, where 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, so that the focus is entirely on the behavior of users. In the next section, I discuss the case where technologies are sponsored.
What We Think We Know About Network Industries (Sponsored Technologies)
I turn now to the case in which competing technologies are sponsored by firms that wish to influence the outcome of the standard-setting process, or, more generally, to determine which network wins. Here, the focus is on the strategies and tactics adopted by sponsors. In one case, sponsors have decided to engage in a standards battle. Among the tactics available to such sponsors are:
An interesting aspect of this analysis is that the best technology may not always win the standards battle. This can occur, as noted above, because random events may give an inferior technology an insurmountable early lead. But it can also occur because the cost trajectory of the best technology may make it difficult for it to commit to low future prices. It can also occur, of course, because the sponsor of the best technology chose the wrong marketing tactics.
Finally, it is important to observe that the winner will often choose to make it difficult for others to join its network later. This will occur when 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:
Of course, sponsors will not always choose to play winner take all and compete for the standard. Instead, cooperation to create a standard followed by competition within a standard may occur. This is most likely where users fear of stranding is so great that few users will adopt a product without assurance of what the standard will be. When this occurs, sponsors may agree on a standard and arrange for low-cost licensing of their technologies in order to allow the benefits of standardization to be shared among competing firms. In addition, firms may agree on standards that combine aspects of the technologies of competing sponsors, so as to prevent any sponsor from being disadvantaged in future competition. Alternatively, they may agree to a form of logrolling, in which sponsors rotate in having their technologies chosen as the standard. These tactics are all designed to achieve the cooperation required for standardization and, thus, to avoid delays in market development as users wait and see which standard wins.
Finally, I want to emphasize that firms must be concerned that, after they have supported the adoption of a standard, the sponsor of the winning technology will then attempt to exploit its dominant position, in the ways described above. If that occurs, one alternative is to bring legal action. However, as we know, that is likely to be both costly and difficult, and there is no guarantee that the litigation will succeed. As a result, it may be far better for all sponsors, before the standard is established, to adopt measures that limit the scope for opportunism. These measures may include agreements to cooperate on future technology development, agreements to shift future development to third parties, and commitments to provide information about design changes to all suppliers in a timely manner. Although these are by no means perfect measures, they may be far superior to invoking the legal process after the opportunistic behavior has occurred.
 H. Leibenstein, Bandwagon, Snob, and Veblen Effects in the Theory of Consumers Demand, The Quarterly Journal of Economics (May 1950), reprinted in W. Breit and H.M. Hochman, Readings in Microeconomics, Second Edition (New York: Holt, Rinehart and Winston, Inc., 1971), pp. 115-116.
 J. Rohlfs, A Theory of Interdependent Demand for a Communications Service, Bell Journal of Economics and Management Science (Spring 1974), p. 16.
 P.A. David, Clio and the Economics of QWERTY, American Economic Review (May 1985).
 J. Farrell and G. Saloner, Standardization, Compatibility, and Innovation, Rand Journal of Economics (Spring 1985).
 M. L. Katz and C. Shapiro, Network Externalities, Competition, and Compatibility, American Economic Review (June 1985).
 Potential applications of the theory are even more widespread; the analysis of industrial location provides a good example.
 I have chosen this fairly modest title to signify that not everyone would agree with each of my statements and not everyone, including myself, would apply them in every case.
 For a fuller treatment, see S.M. Besen and J. Farrell, Choosing How to Compete: Strategies and Tactics in Standardization, Journal of Economic Perspectives (Spring 1994).