Clusters, connectivity and Kevin Bacon

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Building a monopoly on the back of network externalities is possible, but only by ignoring the complex reality of human relations.

A few years ago it was still possible to holiday in the troubled but beautiful province of Kashmir. I flew to Delhi, caught a smaller plane to Srinigar, and travelled on by jeep and boat. As a porter carried my bags up a dusty track to my destination, I encountered a friend from London. What a small world, we said.

But there was really no coincidence at all. If I had been dropped by helicopter at some random point on Earth, and had met an acquaintance, that would have been an extraordinary event. There are 6 bn people in the world, and no-one can know more than a tiny fraction of them. But my arrival in Kashmir was not at all random. Travel agents in London deal with a small number of representatives in India, who deal in turn with a few providers in Kashmir. If my friend and I had expressed similar requests, it was not surprising we should end up at the same place. We were in closely connected networks.

Network externalities are a new buzzword in business economics. Connectedness is vital, and it is best to be connected to the largest network. Telephones are the archetype of the network externality. There is no point in being the only person with a telephone, and the more people with them the more valuable my phone becomes. Such network externalities give huge advantages to early, large, players. There are around 2 billion telephones in the world, and the company which has the highest proportion of this population signed up will attract most new subscribers.

There is one problem with this analysis. It is not how the telephone industry is organised. The world telephone system consists of many operators, large and small. Most provide service in a particular geographical area, and connect each other’s calls through negotiated access agreements. And, whatever large telcos may wish or say, the number of providers of telecommunications services is increasing.

Perhaps this happened because of government regulation of access and interconnection. But the banking industry evolved in just the same way without regulation. You open a current account because you want to make payments to other people. Most of the people to whom you want to make payments live in the same area. So early banks were local, and each bank made arrangements with banks in other towns and countries for the occasional transaction that needed these connections. Today, a network of clearing and correspondent agreements ensures that you can make a payment through your local bank to anyone in the world.

Suppose one bank – Silibank – decides that it will only make or accept payments from other Silibank accounts. If it signed up enough customers, then it would be able to exploit the network externality. Everyone would need a Silibank account, and it would become the dominant bank in the world. It would be a brilliant strategy if it succeeded. But there is not the slightest chance of it succeeding. All Silibank’s customers would desert it for more flexible competitors.

Cash machines are another network, but one which does not require ‘any to any’ connectivity. You don’t need access to every cash machine in the world, just to a reasonably large number. Yet the cash machine networks work in just the same way as payment systems and telephones. There is some advantage to the banks with the most machines, but in practice negotiations between banks over interconnection ensure that all customers are served.. These payment arrangements are the product of market forces, not regulation.

The same organisation is found in other network industries, such as gas and electricity distribution, or airlines. There are many operators, large and small, and they organise interchange and access. Although not universal these arrangements are general enough to allow the system to work as a network. And interconnectedness between competing providers is true of the most famous new network of all – the internet .

The model of network externalities – in which the company that is first to create the largest network denies access to competitors and establishes an unassailable monopoly – is a theoretical possibility. But the only cases of it actually happening seem to be those in which governments have imposed it, as they did for national telephone services. Where evolution is left to market forces, the usual outcome is competition, interconnection and access.

And the phenomenon I discovered in Kashmir explains why. Graph theorists, who study networks, illustrate it through the Kevin Bacon hypothesis. Everyone who has ever been in a movie was in a movie with someone who was in a movie with someone who was in a movie with Kevin Bacon. Kevin Bacon is as much – and as little – the centre of the movie world as Jack Nicholson or Greta Garbo.

Kevin Bacon, and our ‘small world’ experience show that overlapping clusters produce a very high degree of connectedness from a relatively modest number of direct links. That is why market forces ensure that network industries are organised that way. And why there is more than one agent in Hollywood, more than one bank, and why natural monopolies based on network externalities do not often exist.

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