Network Effects and Competition: An Empirical Analysis of the Home Video Game Industry

Abstract

Building on the Resource-Based View of the firm, we advance the idea that a firm's customer network can be a strategic asset. We suggest that network effects are a function of network size (i.e., installed customer base) and network strength (i.e., the marginal impact of a unit increase in network size on demand). We empirically study these network effects in the 16-bit home video game industry in which the dominant competitors were Nintendo and Sega. In the spirit of the new empirical IO framework, we estimate a structural econometric model assuming the data are equilibrium outcomes of the best fitting non-cooperative game in price and advertising. After controlling for other effects, we find strong evidence that network effects are asymmetric between the competitors in the home video game industry. Specifically, we find that the firm with a smaller customer network (Nintendo) has higher network strength than the firm with the larger customer base (Sega). Thus, our results provide a possible explanation for this situation in which the firm with a smaller customer network (Nintendo) was able to overtake the sales of a firm with a larger network size (Sega). These empirical results suggest that the ultimate outcome in a competitive market with network effects is more complex than simply accepting that the firm with the largest installed customer base will always be the winner.

Keywords: network externalities; technology lock-in; new empirical industrial organization

JEL Classification: L1, C7