COORDINATION PROBLEM BEHIND TECHNOLOGICAL UPGRADES WITH SPILLOVER EFFECTS

by  Elena Salomone

In various fields of economic activity technological upgrades may bring various efficiencies. These may be passed on to consumers, in the form of enhanced quality of the goods or services concerned or of lower prices. The introduction of innovative technologies may therefore improve social welfare. However, it often requires a substantial initial investment cost.

The decision to invest depends on the proportion of the social benefits generated by the new technology that the investor will be able to obtain. This “degree of appropriability” is affected by the presence of spillovers effects. Indeed, when the benefits stemming from a new technology increase with its adoption in the market, the decision of one operator affects other operators as well. The existence of such spillover implies that one operator’s decision to invest in the introduction of the technology will be influenced by the other operators’ decision. Thus, the introduction of the technological upgrade may require a certain degree of coordination among the operators active in the market.

Operators’ incentives may autonomously lead to an optimal investment decision (“self-coordination”), as the net present value of the expected benefits is larger than that of the costs associated with the investment. However, in some cases the individually rational choice may not be the socially optimal one. In particular, distortions may arise because each operator ignores the spillover effects on other operators when making its investment decision. This may lead to a “wait and see” strategy where each firm waits for the others to make the first move.

Recent technological developments in the railway sector provide a good example of the coordination problem depicted above. Several innovative and clean technologies have been developed that could be adopted. These include, for instance, the Future Railways Mobile Communication System, Digital Automated Coupling, Automatic Train Operation and electric catenary and batteries. The adoption of these technologies would be socially desirable for several reasons, in particular environmental ones. Some of these would have a direct impact on the level of CO2 emissions and other pollutants, as well as railway noise; others would indirectly contribute to the same objectives, as they could foster the modal shift to rail by increasing the efficiency of rail transport. Yet, it seems that market forces alone may not lead to their introduction, i.e. self-coordination fails.

One of the reasons behind this impasse is that the benefits will be obtained only once the technology is introduced at a certain scale. This is because, in the migration phase, interoperability with the existing network and rolling stock must be ensured, significantly reducing the scope of utilization of such technologies. For instance, such a problem is affecting the introduction of Digital Automated Coupling (DAC) in Europe. DAC is a technology that automatises the coupling process and the other tasks that are necessary for freight train assembly, leading to a reduction of shunting times and an increase of network capacity and wagons’ productivity. Wagons using manual coupling and wagons with DAC systems are not natively compatible with one another and can only be operated together using an adapter physically installed on the DAC or a buffer wagon with hybrid couplings. As freight trains are increasingly assembled using wagons belonging to different operators, there exists a coordination problem among railway operators: one operator would have the incentive to wait until other operators have converted their fleet, in order to reap the full benefits of migrating to the new system. In this particular case, not only in the migration phase the investors could not reap the full benefits, but they would also likely have to bear additional costs, related to the use of the abovementioned adaptors or buffer wagons to be able to use the upgraded fleet; alternatively, they would have to give up using the upgraded fleet in the transition period. These mechanisms lead to a suboptimal rate of introduction of the new technology.

When self-coordination does not work, how can the coordination issue be overcome?

One possible solution is a command-and-control approach, for instance making the introduction of the desired technology mandatory through policy interventions. Another solution is subsidising the introduction of the technology. Which one is preferable will depend on the characteristics of the technology and sector at hand.

For instance, while in the railway sector it would – in principle – be possible to make the introduction of innovative technologies mandatory, envisaging a transition period, this is not always a feasible route, mainly because some of these technologies are still at a prototype stage, which implies that unforeseeable challenges may arise, or that their technical useful life might be shorter than expected. To foster the introduction of these technologies it might thus be best to rely on subsidies to the first movers who undertake the risks related to an early migration. This is in line with the economic literature, such as Katz and Shapiro (1986) and Rauch (1993), who advocate for the use of subsidies to address the first-mover disadvantage.

The practical implementation of this solution, however, entails addressing several issues related to subsidy design:

• which costs the subsidy should cover: should it cover just the initial investment costs (or a portion thereof), or also additional costs that could arise during the transition period (such as, in the case of DAC, the opportunity cost related to the impossibility to use the upgraded fleet)?;
• subsidization should stop once the technology has reached a certain threshold of market penetration, such that the remaining market operators autonomously have the incentive to sustain the investment cost;
• subsidy recipients should be chosen in a way that does not confer the beneficiaries an undue advantage, to minimise the distortions to competition.

The provision of subsidies is apt to encourage the adoption of new technologies, but should be backed up by a careful analysis of the competitive dynamics in the market to ensure that the subsidy design is consistent with the policy objectives and does not unduly disrupt the competitive process.