Network Effects and International Trade in a Small Open Economy

One of the most important trends in the world economy in recent decades has been the improvement of the communications networks (e.g., the Internet and satellite communications networks). Technology penetrates all aspects of human life and in recent years has connected people all over the globe through the World Wide Web. With lower communications costs have come a growing connectivity of individuals and organizations achieved through market integration (or market expansion) and a consequent increase in the flow of differentiated services (e.g., business software development, accounting, data processing) across cities (or regions). Communications networks are often characterized by the existence of strong network effects the more people who use it, the more useful it is to any individual user. The seminal contribution on the role of network effects (or network externalities) is Katz and Shapiro (1985), which analyzes oligopolistic competition between providers of network services.1) However, as their model is based on a single (or closed) market for a consumption good, the role of network effects as a determinant of comparative advantage is downplayed in the analysis. As its primary contribution, this study examines how the network effects of communications activities and trading opportunities interact to determine the trade structure in a small open economy setting. We also emphasize an important concept related to network externalities interconnectivitywhich allows users of a network to communicate with users of other networks.2) For these purposes we construct a small open economy model of trade with