Regulation by Networks

Amitai Aviram , University of Illinois College of Law

Abstract

The Private Ordering literature examines how non-government institutions mitigate opportunistic behavior in transactions. It emphasizes two elements that facilitate cooperation and reduce opportunism: repeated-play and reputation. This paper explores the implications of a third element: network effects.

Network effects create an incentive for a unique form of opportunism that exists only in network environments – degradation. On the other hand, network effects facilitate mechanisms that may be very effective in regulating opportunism. Therefore, in certain industries, networks (institutions characterized by significant network effects) regulate connectivity (mitigate opportunism), largely displacing in that role the parties to the transaction and the government.

This paper identifies mechanisms used by networks to reduce opportunism, and market characteristics that are conducive to the effectiveness of these mechanisms (and therefore to the efficiency of networks as connectivity regulators). This helps explain the prevalence of networks in certain markets as compared to others, and gives tools to assess networks’ ability to self-regulate and anticipate the type of opportunism a given network is more likely to be susceptible to.