Product Strategy for Innovators in Markets with Network Effects

This paper examines four alternative product strategies available to an innovating firm in markets with network effects: single-product monopoly, technology licensing, product-line extension, and a combination of licensing and product-line extension. We address three questions. First, what factors affect the attractiveness of each of the four product strategies? Second, under what conditions will any particular strategy dominate the others? Third, what is the impact of licensing fees on the profitability of a licensing strategy? We show that offering a product line utilizes consumer heterogeneity to increase the total user base and is superior to free licensing when the innovator's cost of producing a low-quality product is low and network effects are weak. However, because of the advantage of licensing in generating a larger installed base, free licensing can dominate line extension when network effects are strong, even if the innovator suffers no cost disadvantage compared to the competitor. We also show that paid licensing trumps free licensing when the clone product has a high quality or a low cost, regardless of network effect. Finally, strong network effects make a lump-sum fee more profitable than a royalty fee (or a combination of both) because a royalty fee reduces the licensee's production.