Network externalities and institutional adaptation

Abstract

This paper presents a dynamic framework that explains how a set of institutions emerges when players extrapolate across multiple games. It explores the existence of a fundamental circularity whereby the high convention in one game reinforces the high convention in others, and vice versa, such that one possible outcome is a socially advantageous regime combining the high conventions. Likewise, the low conventions also reinforce one another to form a socially disadvantageous regime. A convention in one game reinforces the corresponding convention in the other game by altering the payoff structure in favor of the latter. The payoff structures of the games explored here are driven by the competition between the two alternative regimes. In the long run, however, the regime that adapts better into its milieu, or equivalently, is more firmly rooted in past adaptation, will overcome the alternative. This dominant regime will determine the asymptotic outcome in all games.