Network issues and payment systems

Credit & Financial Management Review, First Quarter 1998 by McAndrews, James J

Underproduction

Another issue is the possible underproduction of network services. Economic models suggest that market production. of network services may often be inefficiently low because using a network imposes an external effect on other users of that network, an effect these other users typically disregard in making their own production decisions.5 Since expanding a network requires additional facilities, the new facilities create the possibility for new products and services. For example, suppose a business installs a fax machine, adding one machine to an existing network of 100 machines owned by other businesses. This installation allows the business to send messages to 100 other businesses, which, in turn, can send messages to the business with the new fax machine. The existing fax machine owners generally place a positive value on the extra machine, but typically do not subsidize its installation. Businesses deciding whether to install a new fax machine would not take into account the positive effect on other businesses. Thus, an externality exists in the purchase and use of network goods.6 Because the prices for network goods and services do not typically reflect this externality, the consumption of network goods and services is expected to be inefficiently low in a competitive market: A business might decide it is too expensive to install the new fax machine, even though the value to the 100 other firms exceeds the cost of the machine. Standards The process of setting standards for network components is vital to achieving the compatibility that makes network complementarity fully possible. Setting standards can be done, as in the U.S. railroad case, by the marketplace, through cooperation (industry forums on setting standards), or by the government. Although the U.S. railroad industry developed a standard gauge through market forces at work over a half a century, one analyst of the issue called for legislation to lead the way in adopting one of the early gauges as a standard. Puffert quotes an unsigned commentary from an 1832 issue of the American Railroad Journal: It is a matter of regret with many of the friends of railroad improvements that no measure has been taken to insure a uniform width of track. The advantages of such uniformity must be perfectly obvious...we are forced to conclude that this discrepancy in the width of tracks will ultimately produce an infinitude of vexation, transfers and delays which might easily have been avoided. The establishment of a particular width, by statute, in two or three of the principal States, would probably have influence sufficient to produce the desired uniformity in most cases throughout the United States.

This commentator suggests the advantage of a mandatory, or legislated, standard. The "infinitude of vexation," occasioned by differing gauges, that persisted for decades could have been avoided. The disadvantage of the mandatory approach is that the legislature may decide on an inferior gauge. Today, many industries cooperate in setting technical standards for products. For example, checks, smart cards, ATM cards, credit cards, and other components of the payment system are all carefully designed to maintain compatibility among different network components and providers of network services. The placement of information on the magnetic stripe on cards, the encryption devices and codes, and other technical standards must be common among the parties to a card-based payment for the system to operate. A cooperative industry sponsored approach to standardization can achieve rapid adoption of standards while allowing those with the greatest interests and technical expertise to participate in setting the standards.