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Price Competition and Compatibility in the Presence of Positive Demand Externalities

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Author Info

  • Jinhong Xie

    (William E. Simon Graduate School of Business Administration, University of Rochester, Rochester, New York 14627)

  • Marvin Sirbu

    (Department of Engineering and Public Policy, Carnegie Mellon University, Pittsburgh, Pennsylvania 15213)

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    Abstract

    In many cases, the benefit to a consumer of a product increases with the number of other users of the same product. These demand interdependencies are referred to in the literature as positive demand externalities or network externalities. This paper examines the dynamic pricing behaviors of an incumbent and a later entrant, with special attention to the impacts of demand externalities, compatibility, and competition on prices and profits. Defining market power as the ability to price above a competitor without losing market share, we show how demand externalities and installed base combine to confer market power. We model optimal pricing as a differential game with the optimal price trajectory established as Nash open-loop controls. For a duopoly durable goods market with strong demand externalities, the results show an increasing price trajectory can be optimal. As expected, a new entrant is better off if its products are compatible with those of the incumbent, especially when demand externalities are strong and the installed base of the incumbent is large. Less intuitively, the incumbent as well may be better off agreeing on common standards. The comparison of monopoly and duopoly shows that under strong demand externalities and a small installed base, the incumbent profits from compatible entry.

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    File URL: http://dx.doi.org/10.1287/mnsc.41.5.909
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 41 (1995)
    Issue (Month): 5 (May)
    Pages: 909-926

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    Handle: RePEc:inm:ormnsc:v:41:y:1995:i:5:p:909-926

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    Related research

    Keywords: diffusion; new products; dynamic pricing; duopoly competition; network externalities; compatibility; standards;

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    Cited by:
    1. Didier LAUSSEL & Ngo Van LONG & Joana RESENDE, 2014. "Network E¤ects, Aftermarkets and the Coase Conjecture : A Dynamic Markovian Approach," Cahiers de recherche 06-2014, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
    2. Mason, Robin, 2000. "Network externalities and the Coase conjecture," European Economic Review, Elsevier, vol. 44(10), pages 1981-1992, December.
    3. Fabio Maria Manenti & Ernesto Somma, 2002. "One-Way Compatibility, Two-Way Compatibility and Entry in Network Industries," series 0004, Dipartimento di Scienze Economiche e Metodi Matematici - Università di Bari, revised Jan 2002.
    4. Narayanan, V.K. & Chen, Tianxu, 2012. "Research on technology standards: Accomplishment and challenges," Research Policy, Elsevier, vol. 41(8), pages 1375-1406.
    5. Ho-Chyuan Chen & Chien-Chen Chen, 2011. "Compatibility Under Differentiated Duopoly with Network Externalities," Journal of Industry, Competition and Trade, Springer, vol. 11(1), pages 43-55, March.
    6. Alexei Parakhonyak & Nick Vikander, 2013. "Optimal Sales Schemes for Network Goods," Discussion Papers 13-11, University of Copenhagen. Department of Economics.
    7. Sadou, Karim, 2002. "L’impact des externalités de réseau sur le processus de décision du consommateur," Economics Papers from University Paris Dauphine 123456789/5855, Paris Dauphine University.
    8. Argenton, C. & Prüfer, J., 2012. "Search engine competition with network externalities," Open Access publications from Tilburg University urn:nbn:nl:ui:12-5117898, Tilburg University.
    9. Chen, Jing & Grewal, Ravneet, 2013. "Competing in a supply chain via full-refund and no-refund customer returns policies," International Journal of Production Economics, Elsevier, vol. 146(1), pages 246-258.
    10. José López-Sánchez & José Arroyo-Barrigüete & Domingo Ribeiro, 2008. "Development of a technological competition model in the presence of network effects from the modified law of Metcalfe," Service Business, Springer, vol. 2(2), pages 83-98, June.
    11. Lange, Rense & McDade, Sean & Oliva, Terence A., 2001. "Technological choice and network externalities: a catastrophe model analysis of firm software adoption for competing operating systems," Structural Change and Economic Dynamics, Elsevier, vol. 12(1), pages 29-57, March.
    12. Ting Zhu & Vishal Singh & Anthony Dukes, 2011. "Local competition, entry, and agglomeration," Quantitative Marketing and Economics, Springer, vol. 9(2), pages 129-154, June.

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