Price Competition in Two-Sided Markets with Heterogeneous Consumers and Network Effects

Date: 2013-10
By: Lapo Filistrucchi (CentER, TILEC, Tilburg University and Department of Economics, University of Florence)
Tobias J. Klein (CentER, TILEC, Tilburg University)
URL: http://d.repec.org/n?u=RePEc:net:wpaper:1320&r=net
We model a two-sided market with heterogeneous customers and two heterogeneous network effects. In our model, customers on each market side care differently about both the number and the type of customers on the other side. Examples of two-sided markets are online platforms or daily newspapers. In the latter case, for instance, readership demand depends on the amount and the type of advertisements. Also, advertising demand depends on the number of readers and the distribution of readers across demographic groups. There are feedback loops because advertising demand depends on the numbers of readers, which again depends on the amount of advertising, and so on. Due to the difficulty in dealing with such feedback loops when publishers set prices on both sides of the market, most of the literature has avoided models with Bertrand competition on both sides or has resorted to simplifying assumptions such as linear demands or the presence of only one network effect. We address this issue by first presenting intuitive sufficient conditions for demand on each side to be unique given prices on both sides. We then derive sufficient conditions for the existence and uniqueness of an equilibrium in prices. For merger analysis, or any other policy simulation in the context of competition policy, it is important that equilibria exist and are unique. Otherwise, one cannot predict prices or welfare effects after a merger or a policy change. The conditions are related to the own- and cross-price effects, as well as the strength of the own and cross network effects. We show that most functional forms used in empirical work, such as logit type demand functions, tend to satisfy these conditions for realistic values of the respective parameters. Finally, using data on the Dutch daily newspaper industry, we estimate a flexible model of demand which satisfies the above conditions and evaluate the effects of a hypothetical merger and study the effects of a shrinking market for offline newspapers.
Keywords: two-sided markets, indirect network effects, merger simulation, equilibrium, competition policy, newspapers
JEL: L13 L40 L82
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Coordination and Lock-In: Competition with Switching Costs and Network Effects

Joseph Farrell and Paul Klemperer (2007) “Coordination and Lock-In: Competition with Switching Costs and Network Effects," Chapter 31 in Handbook of Industrial Organization, Volume 3, 2007, Pages 1967–2072.

source: http://dx.doi.org/10.1016/S1573-448X(06)03031-7; see also http://escholarship.org/uc/item/9n26k7v1 for PDF

original Abstract:

Switching costs and network effects bind customers to vendors if products are incompatible, locking customers or even markets in to early choices. Lock-in hinders customers from changing suppliers in response to (predictable or unpredictable) changes in efficiency, and gives vendors lucrative ex post market power – over the same buyer in the case of switching costs (or brand loyalty), or over others with network effects. Firms compete ex ante for this ex post power, using penetration pricing, introductory offers, and price wars. Such “competition for the market” or “life-cycle competition” can adequately replace ordinary compatible competition, and can even be fiercer than compatible competition by weakening differentiation. More often, however, incompatible competition not only involves direct efficiency losses but also softens competition and magnifies incumbency advantages. With network effects, established firms have little incentive to offer better deals when buyers’ and complementors’ expectations hinge on non-efficiency factors (especially history such as past market shares), and although competition between incompatible networks is initially unstable and sensitive to competitive offers and random events, it later “tips” to monopoly, after which entry is hard, often even too hard given incompatibility. And while switching costs can encourage small-scale entry, they discourage sellers from raiding one another’s existing customers, and so also discourage more aggressive entry. Because of these competitive effects, even inefficient incompatible competition is often more profitable than compatible competition, especially for dominant firms with installed-base or expectational advantages. Thus firms probably seek incompatibility too often. We therefore favor thoughtfully pro-compatibility public policy.

Keywords

* Switching costs;
* Network effects;
* Lock-in;
* Network externalities;
* Co-ordination;
* Indirect network effects

JEL classification

* L130;
* L150;
* L120;
* L140;
* D430;
* D420