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Economics Working Papers >
Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26170
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| Title: | Network Effects, Nonlinear Pricing and Entry Deterrence |
| Authors: | Sundararajan, Arun |
| Issue Date: | Jul-2003 |
| Series/Report no.: | EC-03-17 |
| Abstract: | A number of products that display positive network effects are used in
variable quantities by heterogeneous customers. Examples include
corporate operating systems, infrastructure software, web services and
networking equipment. In many of these contexts, the magnitude of
network effects are influenced by gross consumption, rather than simply
by user base. Moreover, the value an individual customer derives on
account of these network effects may be related to the extent of their
individual consumption, and therefore, the network effects may be
heterogeneous across customers. This paper presents a model of nonlinear
pricing in the presence of such network effects, under incomplete
information, and with the threat of competitive entry. Both homogeneous
and heterogeneous network effects are modeled. Conditions under which a
fulfilled-expectations contract exists and is unique are established.
While network effects generally raise prices, it is shown that
accompanying changes in consumption depend on the nature of the network
effects — in some cases, it is optimal for the monopolist to
induce no changes in usage across customers, while in others cases,
network effects raise the usage of all market participants. Optimal
pricing is shown to include quantity discounts that increase with usage,
and may also involve a nonlinear two-part tariff. These results
highlight the impact of network effects on the standard trade-off
between price discrimination and value creation, and have important
implications for pricing policy. The threat of entry generally lowers
profits for the monopolist, and increases customer surplus. When network
effects are homogeneous across customers, the resulting entry-deterring
monopoly contract is a fixed fee and results in the socially optimal
outcome. However, when the magnitude of heterogeneous network effects is
relatively high, there are no changes in total surplus induced by the
entry threat, and the price changes merely cause a transfer of value
from the seller to its customers. The presence of network effects, and
of a credible entry threat, are also shown to increase distributional
efficiency by reducing the disparity in relative value captured by
different customer types. Regulatory and policy implications of these
results are discussed. |
| URI: | http://hdl.handle.net/2451/26170 |
| Appears in Collections: | Economics Working Papers
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