Nonlinear Pricing with Local Network Effects

Abstract

This paper presents a model of second-degree price discrimination by a monopolistic seller who offers a menu of price-quantity pair contracts to consumers located in a social network. Network effects are local as consumers' private valuations are increasing in their friends' adoption decisions. When designing the optimal set of contracts, the seller takes into account how these local network effects are generated over the social network. Increased participation generates externalities through a ''market size effect'' (higher participation due to higher valuations) and a ''distribution effect'' (consumers upgrade to a higher quantity contract). Local network effects can induce the seller to offer contracts to some consumer segments at a loss (e.g., by offering a free-of-charge plan). Due to the combination of network effects and asymmetric information a complete market failure can occur, i.e., no output is produced despite some production is socially desirable.

Keywords: Monopoly pricing, price discrimination, social networks, network externalities, strategic complements

JEL Classification: D42, D82, L12, L14