Complementary Online Services in Competitive Markets: How Firms Should Adjust Their Strategies Due to Network Effects

Abstract:     
A growing number of firms are strategically utilizing IT and the Internet to provide online services to consumers who buy their products. Online services differ from traditional services, such as maintenance services, because they often promote interactivity among the firm’s customers and exhibit positive network effects. In this paper, we model the competition between two firms that sell a differentiated product, when each firm can offer a complementary online service to its customers. We examine how the market equilibrium changes when the service exhibits network effects, and determine how firms should adjust their strategies to account for such effects. Specifically, we find that when the service exhibits network effects, a firm’s decision whether to offer the service depends on the competitor’s decision as well as on the competitor’s service quality. When the service does not exhibit network effects, this is not the case. In addition, if the service exhibits network effects the two firms may be caught in a Prisoner’s Dilemma; a situation that does not arise in the absence of network effect. We also show that technological progress that enhances the value of the network to consumers can reduce firms’ profits when both offer the service. An increase in the size of the market can also have a negative effect on profits when the service exhibits network effects, but not otherwise. Finally, unlike previous works on products with network effects, showing under-provision in the context of a monopoly, we show that both under- and over-provision of services can arise in a competitive setting.

Number of Pages in PDF File: 50

Keywords: Online Services, Network Effects, e-Commerce, Analytical Modeling

JEL Classification: C70, D21, D43, D40, D60, D62, L86

working papers series