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Two-Sided Network Effects: A Theory of Information Product Design

  • Geoffrey G. Parker

    ()

    (Tulane University, New Orleans, Louisiana 70118)

  • Marshall W. Van Alstyne

    ()

    (Boston University, and Massachusetts Institute of Technology, Boston, Massachusetts 02215)

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    How can firms profitably give away free products? This paper provides a novel answer and articulates trade-offs in a space of information product design. We introduce a formal model of two-sided network externalities based in textbook economics---a mix of Katz and Shapiro network effects, price discrimination, and product differentiation. Externality-based complements, however, exploit a different mechanism than either tying or lock-in even as they help to explain many recent strategies such as those of firms selling operating systems, Internet browsers, games, music, and video. The model presented here argues for three simple but useful results. First, even in the absence of competition, a firm can rationally invest in a product it intends to give away into perpetuity. Second, we identify distinct markets for content providers and end consumers and show that either can be a candidate for a free good. Third, product coupling across markets can increase consumer welfare even as it increases firm profits. The model also generates testable hypotheses on the size and direction of network effects while offering insights to regulators seeking to apply antitrust law to network markets.

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    File URL: http://dx.doi.org/10.1287/mnsc.1050.0400
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    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 51 (2005)
    Issue (Month): 10 (October)
    Pages: 1494-1504

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    Handle: RePEc:inm:ormnsc:v:51:y:2005:i:10:p:1494-1504
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    1. Hal R. Varian, 1994. "Sequential Provision of Public Goods," Public Economics 9401003, EconWPA.
    2. Jean-Charles Rochet & Jean Tirole, 2014. "Platform Competition in Two-Sided Markets," CPI Journal, Competition Policy International, vol. 10.
    3. Patrick DeGraba, 1996. "Why Lever into a Zero-Profit Industry: Tying, Foreclosure, and Exclusion," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 5(3), pages 433-447, 09.
    4. William James Adams & Janet L. Yellen, 1976. "Commodity Bundling and the Burden of Monopoly," The Quarterly Journal of Economics, Oxford University Press, vol. 90(3), pages 475-498.
    5. Yannis Bakos & Erik Brynjolfsson, 1999. "Bundling Information Goods: Pricing, Profits, and Efficiency," Management Science, INFORMS, vol. 45(12), pages 1613-1630, December.
    6. Chaudhri, Vivek, 1998. "Pricing and efficiency of a circulation industry: The case of newspapers," Information Economics and Policy, Elsevier, vol. 10(1), pages 59-76, March.
    7. Katz, Michael L & Shapiro, Carl, 1985. "Network Externalities, Competition, and Compatibility," American Economic Review, American Economic Association, vol. 75(3), pages 424-40, June.
    8. Arthur, W Brian, 1989. "Competing Technologies, Increasing Returns, and Lock-In by Historical Events," Economic Journal, Royal Economic Society, vol. 99(394), pages 116-31, March.
    9. S. J. Liebowitz & Stephen E. Margolis, 1994. "Network Externality: An Uncommon Tragedy," Journal of Economic Perspectives, American Economic Association, vol. 8(2), pages 133-150, Spring.
    10. Armstrong, Mark, 2002. "Competition in two-sided markets (2002 version)," MPRA Paper 42863, University Library of Munich, Germany.
    11. Mongell, Susan & Roth, Alvin E, 1991. "Sorority Rush as a Two-Sided Matching Mechanism," American Economic Review, American Economic Association, vol. 81(3), pages 441-64, June.
    12. Salinger, Michael A, 1995. "A Graphical Analysis of Bundling," The Journal of Business, University of Chicago Press, vol. 68(1), pages 85-98, January.
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