The mpact or the nternet on rinancial marke units are sold, everything else being equal. In a traditional net- size and profitability of exchanges and firms affected by mar- work such as the Internet, network externalities arise because ket liquidity considerations as discussed above. Moreover, con a typical subscriber can reach more subscribers in a larger sumers are willing to pay more for the high liquidity exchange network Therefore, its profits can be a large multiple of profits of other exchanges. Similar inequality arising out of network external- In a virtual network, network externalities arise because es occurs in many other products and services. larger sales of component a induce larger availability of com plementary components B1,. Bn, thereby increasing the Intensification of competitio value of component A. The increased value of component A In network markets, the addition of new competitors, say results in further positive feedback. under conditions of free entry, does not change the market structure in any significant way once few firms are in opera. For example, the existence of an abundance of windows. tion. The addition of a fourth competitor to a triopoly hardly compatible applications increases the value of windows. In a changes the market shares, prices, and profits of the three top financial exchange market, the abundance of orders on both competitors. This is true even under conditions of free entry sides of the market, that is, the" thickness"or high liquidity of the market, decreases the variance of expected price and However, the fact that the natural equilibrium in network increases the payoff of traders. In turn, this brings extra liq- industries is winner-take-most with very significant market idity to the market resulting in increasing volume inequality inequality does not imply that competition is weak. To the con- among financial exchanges. trary, the competition race on which firm will create the top platform or be the top exchange, and reap most of the bene- Economic theory and empirical observation have shown fits is, in fact, very intense. moreover, the network also has an at markets with strong network effects, such as financial expansionary effect as it typically makes it easier and cheap. exchange markets and many others facilitated by the Internet, er to buy the good or service. Thus, the size of the market also are"winner-take-most"markets when the product offerings expands of firms are differentiated. that is in these markets there is extreme market share and profits inequality. The market In a way, it may seem paradoxical that there is intensifica- share of the largest firm can easily be a multiple of the mar- tion of competition combined with increasing market concen- ket share of the second largest. The second largest firm's tration, since that is not possible in non-network markets. But market share can be a multiple of the market share of the in network markets, and markets facilitated by the Internet, third, and so on. This geometric sequence of market shares intensification of competition goes hand-in-hand with increas implies that, even for a small number n, the nth firms market ing market concentration. share is tiny. Under intense competition, small competitors are forced to The Internet's impact on the liquidity of innovate to avoid being completely squeezed out of the mar- financial, business-to-business, and busi- ket. In a very interesting example, radically breaking with tra. ness-to-consumer exchanges dition the island ecn decided to open its limit order book to As a direct consequence of network externalities, high liq. the public so that it can attract more liquidity. Traditionally the uidity of a financial or other exchange increases the value of limit order book was held close to the vest of the specialist or transactions in that exchange, brings in more orders, and fur. the exchange. So far, opening the limit order book to the pub- ther increases liquidity. This leads to the extreme inequality of lic has been successful for Island, but it has not prompted the same action by larger competitors. 1 For a detailed discussion of these issues see Economides (1996) 2 See Economides (1993), (1994). Economides and schwartz(1995) 4 Due to the natural extreme inequality t shares and profits in such markets at any point in time, there should be no presumption that there were nti-competitive actions that were responsible for the creation of the market share inequality or the very high profitability of a top firm. Great inequality in sales and profits is the natural equilibrium in markets with network externalities and incompatible technical standards. No anti-competitive acts are neces- 5 See Economides and Flyer (1998). Table 1, taken from this paper, shows market coverage and prices as the number of firms with incompatible platforms increases Maximum potential sales was normalized to 1.units are sold, everything else being equal. In a traditional net￾work such as the Internet, network externalities arise because a typical subscriber can reach more subscribers in a larger network. In a virtual network, network externalities arise because larger sales of component A induce larger availability of com￾plementary components B1, ..., Bn, thereby increasing the value of component A.1 The increased value of component A results in further positive feedback. For example, the existence of an abundance of Windows￾compatible applications increases the value of Windows. In a financial exchange market, the abundance of orders on both sides of the market, that is, the “thickness” or high liquidity of the market, decreases the variance of expected price and increases the payoff of traders. In turn, this brings extra liq￾uidity to the market resulting in increasing volume inequality among financial exchanges.2 Economic theory and empirical observation have shown that markets with strong network effects, such as financial exchange markets and many others facilitated by the Internet, are “winner-take-most” markets when the product offerings of firms are differentiated.3 That is, in these markets, there is extreme market share and profits inequality. The market share of the largest firm can easily be a multiple of the mar￾ket share of the second largest. The second largest firm’s market share can be a multiple of the market share of the third, and so on. This geometric sequence of market shares implies that, even for a small number n, the nth firm’s market share is tiny.4 The Internet’s impact on the liquidity of financial, business-to-business, and busi￾ness-to-consumer exchanges As a direct consequence of network externalities, high liq￾uidity of a financial or other exchange increases the value of transactions in that exchange, brings in more orders, and fur￾ther increases liquidity. This leads to the extreme inequality of size and profitability of exchanges and firms affected by mar￾ket liquidity considerations as discussed above. Moreover, con￾sumers are willing to pay more for the high liquidity exchange. Therefore, its profits can be a large multiple of profits of other exchanges. Similar inequality arising out of network externali￾ties occurs in many other products and services. Intensification of competition In network markets, the addition of new competitors, say under conditions of free entry, does not change the market structure in any significant way once few firms are in opera￾tion. The addition of a fourth competitor to a triopoly hardly changes the market shares, prices, and profits of the three top competitors.5 This is true even under conditions of free entry. However, the fact that the natural equilibrium in network industries is winner-take-most with very significant market inequality does not imply that competition is weak. To the con￾trary, the competition race on which firm will create the top platform or be the top exchange, and reap most of the bene￾fits is, in fact, very intense. Moreover, the network also has an expansionary effect as it typically makes it easier and cheap￾er to buy the good or service. Thus, the size of the market also expands. In a way, it may seem paradoxical that there is intensifica￾tion of competition combined with increasing market concen￾tration, since that is not possible in non-network markets. But in network markets, and markets facilitated by the Internet, intensification of competition goes hand-in-hand with increas￾ing market concentration. Under intense competition, small competitors are forced to innovate to avoid being completely squeezed out of the mar￾ket. In a very interesting example, radically breaking with tra￾dition, the Island ECN decided to open its limit order book to the public so that it can attract more liquidity. Traditionally the limit order book was held close to the vest of the specialist or the exchange. So far, opening the limit order book to the pub￾lic has been successful for Island, but it has not prompted the same action by larger competitors. The Impact of the Internet on financial markets 1 For a detailed discussion of these issues see Economides (1996). 2 See Economides (1993), (1994), Economides and Schwartz (1995). 3 See Economides and Flyer (1998). 4 Due to the natural extreme inequality in market shares and profits in such markets at any point in time, there should be no presumption that there were anti-competitive actions that were responsible for the creation of the market share inequality or the very high profitability of a top firm. Great inequality in sales and profits is the natural equilibrium in markets with network externalities and incompatible technical standards. No anti-competitive acts are neces￾sary to create this inequality. 5 See Economides and Flyer (1998). Table 1, taken from this paper, shows market coverage and prices as the number of firms with incompatible platforms increases. Maximum potential sales was normalized to 1. 10