Marketing Strategies for Products with Cross-Market Network Externalities

This paper discusses marketing strategies for a manufacturer of a composite product (i.e., a product sold in two parts to two separate types of consumers, which has greater value when used jointly by both consumers). It is assumed that expected sales of one product increase a different type of consumer's willingness to pay for the other product. This is described as a 'cross-market network externality'. Using a parsimonious model, I characterize solutions for a monopolist and for variations on Bertrand-Nash competition with differentiated products. The results demonstrate that in the presence of the cross-market network externality, it is optimal for the price of one product to increase relative to the price of the other product (by comparison with expected prices in the absence of the externality effect). In competition between firms, it is individually rational for each firm to attempt to maximize its own cross-market network externality. However (and counter-intuitively), as all firms strive to increase the cross-market externality related to their products, a worse industry-wide solution results. In other words, the existence of firm-specific cross-market network externalities in Bertrand-Nash competition creates a form of 'Prisoner's Dilemma'. In some multi-firm competitive markets, compatibility between products is a design choice (for example, compatibility between word processors such as Microsoft Word and WordPerfect). Normally, increasing compatibility between products increases the substitutability of the products, often resulting in more competition and lower profits (absent other effects). In a market with cross-market externalities, however, increased compatibility leads to increased profits. The model utilized in this paper has applications to industries as diverse as television, Internet web portals and certain types of Internet browser software. It is expected that the predictions of the model will be tested on a data set from the software industry.