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Vertical Integration and Exclusivity in Platform and Two-Sided Markets

Authors: Lee, Robin S. - Harvard Business School
Keywords: platform competition, two-sided markets, vertical integration, exclusive contracting, dynamic demand, network formation, videogame industry
Issue Date: 2007
Series/Report no.: NET Institute Working Paper;07-39
Abstract: This paper develops techniques to analyze the adoption decisions of both consumers and firms for competing platform intermediaries in two-sided markets, and applies the methodology to empirically measure the impact of vertical integration and exclusive contracting in the sixth-generation of the U.S. videogame industry (2000-2005). I first introduce a framework to structurally estimate consumer demand in these types of hardware-software markets which (i) simultaneously analyzes both hardware and software adoption decisions; (ii) accounts for dynamic issues including the selection of heterogenous consumers across platforms, durability of goods, and agents' timing of purchases; and (iii) explicitly provides the marginal contribution of an individual software title to each platform's installed base of users. Demand results show the gains obtained by a platform provider from exclusive access to certain software titles can be large, and failure to account for dynamics, consumer heterogeneity, and multiple hardware purchases significantly biases estimates. I next specify dynamic network formation game to model the adoption decision of hardware platforms by software providers. Counterfactual experiments indicate that vertical integration and exclusivity benefited the smaller entrant platforms and not the dominant incumbent, which stands contrary to the interpretation of exclusivity as primarily a means of foreclosure and entry deterrence.
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