19 Mar 2012

How networks grow and then shrink in value

The move from abundance to scarcity (or non-rivalry to rivalry) does not just happen as the relative balance between demand and supply changes. It can also happen on a network, as it develops and then reaches capacity. That non-linear process is different from the linear process that we see with a resource (value rising steadily as it grows more scarce) due to the benefits of having more people on a network.

The change from increasing to decreasing value of additional demand goes like this:

At first, additional users (from a low user population) make a communication network more valuable since the fixed cost of the network does not change, but its value increases as there are more people to communicate with. From a water perspective, the same holds true, except that additional users lower the cost per user while the network is within capacity. Until this point, the value per additional user is positive.

But after awhile, there are too many users on the network. A communication network will get slow with congestion. A water network will not be able to deliver adequate water to all who want it. From this point, the value per additional user is negative.

Bottom Line: Some customers are good; too many lead to congestion that harms everyone.


Jay said...

The same is true with transportation networks, especially roadways. This rivalrous behavior indicates such networks should be managed as club goods rather than as public goods to minimize the externalities caused by congestion.(Club goods rather than common pool goods because networks are excludable - you need a license, insurance, vehicle registration, etc. to drive on roads.)

Pricing such goods that have been perceived as free has many political difficultieseven when the economics appear clear.

Shane said...

Apropos, petroleum geologist Kenneth Deffeyes, a "peak oil" guy, had an anecdote (I think in his book Beyond Oil) like this:

He'd been giving a lecture that included a graph of price volatility that he expects to see when rising oil demand meets a stagnant or falling supply: The price rises until it becomes unsustainable, then crashes as demand is destroyed, then rises again as demand returns.

Someone from the telecom industry was in the audience and noted that the graph was similar to one well-known to telco people, except upside down: When a bank of phone lines reaches capacity, everybody gets a busy signal and many of them stop trying to call back. This causes a number of lines to open up, at which point the process repeats.

It turns out that there's a field of study called queueing theory that deals with this problem. :)

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