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Network effects, nonlinear pricing and entry deterrence

Author:
Arun Sundararajan  


Issue Date:
2003


Abstract(summary):

A number of products that display positive network e?ects are used in variable quantitiesby heterogeneous customers. Examples include corporate operating systems, infrastructure software, webservices and networking equipment. In many of these contexts, the magnitude of network e?ects are in?u-enced by gross consumption, rather than simply by user base. Moreover, the value an individual customerderives on account of these network e?ects may be related to the extent of their individual consumption,and therefore, the network e?ects may be heterogeneous across customers. This paper presents a model of nonlinear pricing in the presence of such network e?ects, under incompleteinformation, and with the threat of competitive entry. Both homogeneous and heterogeneous network e?ectsare modeled. Conditions under which a ful?lled-expectations contract exists and is unique are established.While network e?ects generally raise prices, it is shown that accompanying changes in consumption dependon the nature of the network e?ects — in some cases, it is optimal for the monopolist to induce no changesin usage across customers, while in others cases, network e?ects raise the usage of all market participants.Optimal pricing is shown to include quantity discounts that increase with usage, and may also involve anonlinear two-part tari?. These results highlight the impact of network e?ects on the standard trade-o?between price discrimination and value creation, and have important implications for pricing policy. The threat of entry generally lowers pro?ts for the monopolist, and increases customer surplus. Whennetwork e?ects are homogeneous across customers, the resulting entry-deterring monopoly contract is a ?xedfee and results in the socially optimal outcome. However, when the magnitude of heterogeneous networke?ects is relatively high, there are no changes in total surplus induced by the entry threat, and the pricechanges merely cause a transfer of value from the seller to its customers. The presence of network e?ects,and of a credible entry threat, are also shown to increase distributional e?ciency by reducing the disparityin relative value captured by di?erent customer types. Regulatory and policy implications of these resultsare discussed.


Page:
42


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