Wednesday, July 27, 2016

Strategic Choice of Network Externality

Yuanzhu Lu (China Economics and Management Academy, Central University of Finance and Economics, Beijing, China) and Sougata Poddar (Department of Economics, Faculty of Business and Law, Auckland University of Technology) explore Strategic Choice of Network Externality.

ABSTRACT: In many product markets, impact of network externality plays an important role to affect the overall quality of a product. However, the degree or the strength of network externality is assumed as a parameter in most of the literature. We propose a model of vertical product differentiation with two competing firms where the strength of network externality is endogenized as a strategic choice of the high quality firm. We show how the equilibrium market structure and market coverage depend on the cost of choosing the network strength and on the relative quality difference of the competing products. We also show that the relationship between the optimal level of network externalities and the relative quality differences of the products can be monotonic or non-monotonic.

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