Network Effects, Nonlinear Pricing and Entry Deterrence
AbstractA number of products that display positive network effects are used in variable quantities by heterogeneous customers. Examples include corporate operating systems, infrastructure software, web services and networking equipment. In many of these contexts, the magnitude of network effects are influenced by gross consumption, rather than simply by user base. Moreover, the value an individual customer derives on account of these network effects may be related to the extent of their individual consumption, and therefore, the network effects may be heterogeneous across customers. This paper presents a model of nonlinear pricing in the presence of such network effects, under incomplete information, and with the threat of competitive entry. Both homogeneous and heterogeneous network effects are modeled. Conditions under which a fulfilled-expectations contract exists and is unique are established. While network effects generally raise prices, it is shown that accompanying changes in consumption depend on the nature of the network effects -- in some cases, it is optimal for the monopolist to induce no changes in usage across customers, while in others cases, network effects raise the usage of all market participants. Optimal pricing is shown to include quantity discounts that increase with usage, and may also involve a nonlinear two-part tariff. These results highlight the impact of network effects on the standard trade-off between price discrimination and value creation, and have important implications for pricing policy. The threat of entry generally lowers profits for the monopolist, and increases customer surplus. When network effects are homogeneous across customers, the resulting entry-deterring monopoly contract is a fixed fee and results in the socially optimal outcome. However, when the magnitude of heterogeneous network effects is relatively high, there are no changes in total surplus induced by the entry threat, and the price changes merely cause a transfer of value from the seller to its customers. The presence of network effects, and of a credible entry threat, are also shown to increase distributional efficiency by reducing the disparity in relative value captured by different customer types. Regulatory and policy implications of these results are discussed.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by EconWPA in its series Industrial Organization with number 0307002.
Length: 40 pages
Date of creation: 22 Jul 2003
Date of revision:
Note: Type of Document - PDF; prepared on Windows NT; pages: 40 ; figures: included
Contact details of provider:
Web page: http://184.108.40.206
network externalities; network externality; non-linear pricing; screening; adverse selection; price discrimination; information goods; software pricing; Microsoft;
Find related papers by JEL classification:
- D42 - Microeconomics - - Market Structure and Pricing - - - Monopoly
- L11 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Production, Pricing, and Market Structure; Size Distribution of Firms
- L12 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Monopoly; Monopolization Strategies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-07-29 (All new papers)
- NEP-INO-2003-07-29 (Innovation)
- NEP-NET-2003-08-17 (Network Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Sanjeev Dewan & Haim Mendelson, 1990. "User Delay Costs and Internal Pricing for a Service Facility," Management Science, INFORMS, vol. 36(12), pages 1502-1517, December.
- Luis Cabral & David Salant & Glenn Woroch, 1994.
"Monopoly Pricing With Network Externalities,"
- Arun Sundararajan, 2003. "Nonlinear pricing of information goods," Industrial Organization 0307003, EconWPA.
- Erik Brynjolfsson & Chris F. Kemerer, 1996.
"Network Externalities in Microcomputer Software: An Econometric Analysis of the Spreadsheet Market,"
INFORMS, vol. 42(12), pages 1627-1647, December.
- Erik Brynjolfsson & Chris F. Kemerer, 1993. "Network Externalities in Microcomputer Software: An Econometric Analysis of the Spreadsheet Market," Working Paper Series 158, MIT Center for Coordination Science.
- Jean-Charles Rochet & Philippe Chone, 1998. "Ironing, Sweeping, and Multidimensional Screening," Econometrica, Econometric Society, vol. 66(4), pages 783-826, July.
- Gandal, Neil, 1995. "Competing Compatibility Standards and Network Externalities in the PC Software Market," The Review of Economics and Statistics, MIT Press, vol. 77(4), pages 599-608, November.
- Nicholas Economides, 1997.
"The Economics of Networks,"
Brazilian Electronic Journal of Economics,
Department of Economics, Universidade Federal de Pernambuco, vol. 1(0), December.
- Jean-Charles Rochet & Lars A. Stole, 2002.
"Nonlinear Pricing with Random Participation,"
Review of Economic Studies,
Oxford University Press, vol. 69(1), pages 277-311.
- Nicholas Economides, 1997.
"Network Externalities, Complementarities, and Invitations to Enter,"
- Economides, Nicholas, 1996. "Network externalities, complementarities, and invitations to enter," European Journal of Political Economy, Elsevier, vol. 12(2), pages 211-233, September.
- Katz, Michael L & Shapiro, Carl, 1985. "Network Externalities, Competition, and Compatibility," American Economic Review, American Economic Association, vol. 75(3), pages 424-40, June.
- Mandy, David M, 1992. "Nonuniform Bertrand Competition," Econometrica, Econometric Society, vol. 60(6), pages 1293-30, November.
- Shmuel S. Oren & Stephen A. Smith & Robert B. Wilson, 1982. "Nonlinear Pricing in Markets with Interdependent Demand," Marketing Science, INFORMS, vol. 1(3), pages 287-313.
- Jullien, Bruno, 1997.
"Participation Constraints in Adverse Selection Models,"
IDEI Working Papers
67, Institut d'Économie Industrielle (IDEI), Toulouse.
- Jullien, Bruno, 2000. "Participation Constraints in Adverse Selection Models," Journal of Economic Theory, Elsevier, vol. 93(1), pages 1-47, July.
- Stole, Lars A, 1995. "Nonlinear Pricing and Oligopoly," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 4(4), pages 529-62, Winter.
- Jullien, Bruno, 2000. "Competing in Network Industries: Divide and Conquer," IDEI Working Papers 112, Institut d'Économie Industrielle (IDEI), Toulouse, revised Jul 2001.
- A. Michael Spence, 1977. "Entry, Capacity, Investment and Oligopolistic Pricing," Bell Journal of Economics, The RAND Corporation, vol. 8(2), pages 534-544, Autumn.
- Arun Sundararajan, 2003. "Managing Digital Piracy: Pricing, Protection and Welfare," Law and Economics 0307001, EconWPA.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (EconWPA).
If references are entirely missing, you can add them using this form.