by Joanna Stavins
2003 Issue

Network externalities exist when the value of a good or service to a potential consumer increases with the number of other consumers using the same product. For a service characterized by network externalities, adoption and use can be below the socially optimal level because consumers or firms do not take into account the positive effect of their own use on others’ use. A firm may decide not to adopt a technology because its private net benefits from adoption are negative, even though net social benefits may be positive. There could be at least two reasons why electronic check products have been relatively slow to spread: Financial institutions (or their customers) do not find electronic check products sufficiently attractive, and network externalities slow down the rate of adoption of these services. If network externalities are the cause of the slow rate of adoption, then there may be a reason to provide additional incentives to depository institutions to encourage their use.

Using data on individual banks’ use of Federal Reserve electronic check services, the author tests whether local network externalities exist in electronic check services provided by the Federal Reserve. Two tests are applied: a clustering test and a market concentration test. The author finds no evidence that local network externalities exist in the market for electronic check services.

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