Entry-Deterring Nonlinear Pricing with Bounded Rationality

This paper considers an entry-deterring nonlinear pricing problem faced by an incumbent firm of a network good. The analysis recognizes that the installed user base/network of incumbent monopolist has preemptive power in deterring entry if the entrant’s good is incompatible with the incumbent’s network. This power is, however, dramatically weakened by the bounded rationality of consumers in the sense that it is vulnerable to small pessimistic forecasting error when the marginal cost of entrants falls in some medium range. These findings provide a formal analysis that helps reconcile two seemingly contrasting phenomena: on one hand, it is very difficult for a new, incompatible technology to gain a footing when the product is subject to network externalities; on the other hand, new technologies may frequently escape from inefficient lock-in and supersede the old technologies even in the absence of backward incompatibility. Our results therefore shed light on how the market makes transition between incompatible technology regimes.