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Summary

So far in this part, we have only considered models that are static, in the sense that firms simultaneously take their decision at a single point in time. This is clearly a simplified representation of reality but it helped us a great deal to understand the basic principles of oligopoly competition. Now, we want to extend the analysis by incorporating the time dimension. First, in Section 4.1, we examine situations in which firms do not take their decisions simultaneously but sequentially. One firm might indeed have the opportunity to choose its price or its quantity before the other firms in the industry, and it is important to investigate whether such opportunity benefits or hurts the firm. Second, in Section 4.2, we endogenize the number of firms in the industry; that is, assuming that the only impediment to entry is a fixed set-up cost, we analyse the entry decision that precedes price or quantity competition. Our main concern is to compare the number of firms that freely enter the industry, so as to exhaust all profit opportunities, with the number of firms that a social planner would choose. Third, in Section 4.3, we first distinguish endogenous from exogenous sunk cost industries and analyse how market size affects market concentration. We then sketch a stochastic dynamic model of firm turnover that allows us to analyse the effect of market size on the number of firms, their efficiency levels and firm turnover.

Sequential choice: Stackelberg

In the models of the previous chapter, firms were assumed to make their strategic decisions in a simultaneous way. The term ‘simultaneous’ does not have to be taken in its literal sense, though. What is meant by simultaneous decision-making is not that decisions are made at the exact same moment, but rather that firms are not able to observe each other's decision before making their own. While this assumption is reasonable in a large number of market environments, there exist situations where some firms have the possibility to act before their competitors, who are then in a position to observe those firms' previous choices. Take the pharmaceutical industry as an illustration. Because of patent protection, firms set the price of their patented drugs before producers of generic drugs enter the market and set their own price.

Summary

A classic example of asymmetric information problems is the market for used cars. The current owner has private information about product characteristics, whereas buyers only have a vague idea. This asymmetric information problem may result in the breakdown of the market: only lemons (i.e., used cars of poor quality)may be offered for sale or, worse, all sellers may withdraw from the market. Alternatively, if sellers can disclose their information, asymmetric information may result in full information disclosure, so that the asymmetric information is solved. What is the likely outcome and why? This is what we explore in Section 12.1. We start by analysing hidden information problems, where firms do not control the quality of their product but observe the realization of quality, whereas consumers cannot observe quality before buying the product. We also examine hidden action problems that arise when firms are able to invest in the quality of their products; in that case, we explore the impact asymmetric information has on the private investment incentives.

When producers, like car manufacturers, are not able to credibly disclose some relevant information, they will try to use strategic variables to convince consumers that their products are of high quality. In Section 12.2, we focus on advertising and price signalling in a monopoly setting. Wasteful advertising and prices which are distorted away from their full information level may serve as a means to make consumers believe in high product quality. We first analyse the two signals separately and then we investigate how they can be used jointly. Finally, in Section 12.3, we examine how imperfect competition affects the use of prices as a signal of quality. In particular, we show that a high price can signal product quality also under competition.

Asymmetric information problems

When consumers do not observe product quality or other characteristics whereas firms do, market participants face a situation of asymmetric information. In particular, if quality or other characteristics are not controlled by the firm but are realizations of some random variable, we are confronted with a hidden information problem. Otherwise, that is, if the firm chooses quality or product characteristics itself, market participants face a hidden action problem. We consider the two types of problem in turn.

Summary

In the previous chapter, we focused on the positive aspects of R&D by examining the interplay between market structure and innovation. In consequence, we were not too specific about the exact regime of IP protection. In this chapter, we want to adopt a more normative point of view and study how IP protection should optimally be organized. This chapter also provides the reader with a broad description of the realm of IP.

In Section 19.1, we study the link between innovation and IP in an essentially nontechnical way. We describe the appropriability problem of innovation and we consider several ways to close the wedge that this problem drives between social and private rates of return from innovation. We start with the main policy instrument that has been designed to promote innovation, namely the institution of intellectual property and its legal protection (through IP rights such as patents and copyrights). We explain that the main rationale of IP rights is to provide incentives to produce information and knowledge by conferring a monopoly right to the producer. We then compare this institution to other public and private responses (namely rewards and secrecy), and we examine which of these solutions innovators tend to choose in practice.

In Section 19.2, we address some of the previous issues in a more formal way. First, we study the optimal design of IP rights. We start by arguing that the negative impacts that monopolies have on welfare call for limitations on the legal protection conferred by IP rights. What types of limitation? We examine two adjustable dimensions: the length and the breadth. The length simply refers to the duration of the protection, while the breadth refers to the usage the innovator can make of his rights with respect to competitors. Second, we compare the relative merits of rewards, secrecy and patents as mechanisms to encourage innovation and diffusion.

Summary

In this short introductory chapter, we give a broad presentation of the book and indicate how we think it is best to use it. We start by explaining the title of the book: what do we mean by ‘markets’ and by ‘strategies’, and why do we associate the two terms? We argue that it is market power and the exercise of it that relate markets and strategies to one another. Next, we outline the approach that we adopt in this book: we believe in formal modelling, which explains that the book is theory-based; yet, we also believe that it is important not to overload readers with techniques and to motivate the analysis with real-life cases; our aim is thus to blend up-to-date theoretical developments and real-life applications in a rigorous and concise manner. Finally, we describe the level, the scope and the organization of the book.

Markets

Markets allow buyers and sellers to exchange goods and services in return for a monetary payment. Markets come in a myriad of different varieties. Examples are your local farmers’ markets (local) and the market for passenger jets (global), the market for computer software (product) and software support (service), the market for electricity (homogeneous product) and markets for highly specialized steel (differentiated product). These markets may exist in physical or virtual space.

We mostly consider markets in which a small number of sellers set price or quantity strategically, as well as possible other variables, whereas buyers mostly come in large numbers so that they non-strategically react to supply conditions. The reverse situation applies to some procurement markets in which a small number of buyers faces a large number of sellers.We mainly use examples of markets in which buyers are final consumers; however, the formal investigation relies on certain characteristics of markets that also apply to other markets in which buyers are not final consumers but, for example, small retailers, service providers or manufacturers.

Summary

Introduction to Part IV: Product quality and information

So far in this book, we have mainly been dealing with search goods, that is, products or services with features and characteristics that can easily be evaluated before purchase. In contrast, this part of the book examines products and services with characteristics that can only be ascertained upon consumption because they are difficult to observe in advance. We talk here of experience goods.

Managing experience goods is the day-to-day concern of large firms selling consumer goods, such as Nestlė Procter&Gamble or Unilever. These firms frequently introduce new branded products. They are always interested in not only making consumers aware of the product (e.g., through advertising as we have analysed in Chapter 6) but also convincing consumers that the new product satisfies their wants. Perhaps the main challenge when launching a new product is that consumers do not observe the quality of the product, as is typically the case with experience goods. Similarly, firms that enter an otherwise perfectly competitive industry with a patented product (or, alternatively, open new markets with a proprietary technology) often produce an experience good.

These markets are characterized by asymmetric information as consumers have less information than the producers about product quality. In such markets, firms have to convince consumers that their products are of high quality. To this end, firms can use a variety of marketing instruments. This is the topic of the following two chapters. We mostly focus on markets in which a single firm has market power; situations in which multiple firms have market power are more challenging and will not be analysed systematically in this context.

In Chapter 12, we analyse the basic problem of asymmetric information. Adverse selection may lead to a breakdown of quality in the market. If a firm has initially to invest in quality, the effect of asymmetric information on quality provision is ambiguous. In response to an asymmetric information problem, the firm may also choose from an arsenal of marketing devices. Here, we focus on price and advertising signals of quality, both in isolation and in combination.

Summary

This chapter is organized as follows. In Section 8.1, we start by defining formally the three types of price discrimination, which we will refer to as personalized pricing, group pricing, and menu pricing. We cover the latter type in the next chapter. Here, we consider jointly the first two types because, as we will argue, personalized pricing is nothing but an extreme form of group pricing, where the market segmentation is so fine that each separate ‘group’ consists of a single consumer. Both practices rely on the existence of observable and verifiable indicators of the consumers’ willingness to pay. Coupled with the absence of resale among consumers (i.e., arbitrage), this allows the firms to make a specific and unique price offer to each separate group of consumers. The better the information about consumers, the finer the partition of the consumers into groups and the larger the possibilities for firms to extract consumer surplus. If the firm is a monopoly, as we assume in Section 8.2, this is clearly the only effect at play. We thus observe that the discriminating monopolist's profits increase with the quality of the information it has about the willingness to pay of its consumers.

In an oligopoly setting, however, the previous conclusion may not hold because a second effect comes into play. As we show in Section 8.3, price discrimination gives firms more flexibility to respond to their rivals’ actions, which tends to exacerbate price competition and, thereby, to lower profits. Choosing to discriminate becomes thus a strategic decision. As we show below, the balance between the two contrasting forces (surplus extraction and fiercer competition) depends on the quality of the information about consumers and on the relative importance of the different groups of consumers.

Price discrimination

In this section, we first propose a general typology of price discrimination practices. We then describe how firms manage to segment the market into well-recognized groups of consumers and sometimes, to acquire information about individual reservation prices.

Summary

Introduction to Part VII: R&D and intellectual property

Early March 2014, one could read in the press that Twitter had paid IBM $36 million for 900 patents in order to avoid a lawsuit (Wired.com, March 7), that a German company had won the EU's €2 million inducement prize for innovative vaccine technology (European Commission, March 10), that SanDisk had filed lawsuits against its competitor SK Hynix, alleging misappropriation of confidential trade secrets related to flash memory technology (PCWorld, March 13), that the US Supreme Court was considering making software ineligible for patent protection (Forbes, March 16), that Viacom and YouTube had settled a copyright violations battle out of court, seven years after their dispute began (The New York Times, March 18) and that Nissan and its French partner Renault were planning to integrate their research and development functions (The Japan News, March 19).

What do these events have in common, except that they occurred at about the same time? They all involve intangible assets (i.e., assets that do not have a physical or financial embodiment), which consist of human knowledge and ideas and to which a legal entitlement, called intellectual property (IP), is usually attached. Intangible assets of this kind become increasingly crucial in our economies. In some countries, the investment in intangible assets now matches or even exceeds investment in tangible assets (such as machinery, buildings and equipment). The causes have to be found in the growing importance of service industries, in globalization and in the fast development of information and communication technologies (ICTs).

A clear manifestation of this trend is that firms are increasingly seeking patents, attempting to extend their scope, granting more licences, litigating more and transforming their business models around intellectual property. At the same time, highly reliable open-source software is collectively produced by a decentralized crowd of developers who do not seek any immediate monetary compensation for their efforts; commercial software vendors are contributing to these projects and, even more surprisingly, they do sometimes initiate open-source projects by releasing part of their proprietary source code.

Summary

Introduction to Part IX: Market Intermediation

Most products and services are not sold directly from the producer to the final consumer but pass through intermediaries. Intermediaries and the services they offer are the focus of this last part of the book. We distinguish between the following four major roles of intermediaries.

Summary

Introduction to Part VI: Theory of competition policy

So far in this book, our approach has been mostly positive: we have been concerned with describing and explaining the workings of imperfectly competitive markets. The first chapters helped us to understand what market power is, where it comes from and how it is exerted. In some specific situations, we also compared the outcome that results from the interaction among firms with the social surplus-maximizing outcome. Yet, such comparisons did not give rise to recommendations for a competition authority.

In this part of the book, we change our perspective and adopt a normative approach: now that we understand what is, we can express views about what ought to be, that is, we provide guidance for competition policy. To the extent that competition authorities follow the rules spelled out under this normative approach, this analysis is again helpful to address positive questions: it may help explain why firms choose certain actions when they foresee the reaction of competition authorities.

The basic postulate for competition policy is that competition is desirable as it is a fundamental force to deliver economic efficiency. The problem, as we have already noticed in the previous chapters, is that firms may be tempted to suppress competition as it makes their lives easier. It is thus necessary to edict and enforce a set of rules in order to maintain competition. This is exactly how Neelie Kroes, the European Commissioner for Competition Policy until 2009, defines her role:

The Single Market [i.e., the integrated European market] is a precious achievement, and the best way to keep it functioning effectively is to ensure competition between companies. My job is about acting as a referee of this process. If we think of the European economy as a football match: I set and enforce the rules of the game, in conjunction with the other Commissioners. We make sure it is a fair match, and that there is punishment for people and companies that break the rules and spoil the game for others.

Summary

Intermediation can play an important role in the process through which consumers obtain information. Section 23.1 deals with a number of situations where consumers can access and process information more efficiently if they use the services of an intermediary. First, we consider situations in which consumers may suffer from information overload and in which an information gatekeeper is valuable for consumers. Second, we analyse the role of gatekeepers who provide price information in search markets. Third, we turn to the possibility that the intermediary, through the installation of a recommender system, allows consumers to perform directed search. This potentially allows consumers to drastically reduce their search efforts to obtain the products they like.

In Section 23.2, we turn to asymmetric information problems. We first analyse whether and how an intermediary can alleviate asymmetric information problems between firms and consumers. Possibly, the intermediary can act as a certifier. There is, however, the risk that the intermediary simply extracts rents from the market without providing any services. We then turn to the analysis of reputation systems, where it is not the intermediary's information disclosure but the previous experience of other consumers that allows consumers to make better-informed choices, thereby alleviating asymmetric information problems.

Intermediation and information

Intermediaries that act as information distributors play an increasingly important role, since consumers are limited in their capability to process information. In this section we take a look at consumers with limited information-processing capabilities and the role of ‘infomediaries’ in this context. Instead of relying on an infomediary as a filtering device, consumers may do the filtering themselves. This can be interpreted as an open-access platform from which a consumer has to (randomly) pick some of the information that is provided.

Information overload

Consumers have to be selective when it comes to processing information. This is a critical issue for marketing departments at firms. They have to figure out how they can raise consumers’ interest in their adverts. They can increase the chance of being successful by targeting particular media that address consumers who tend to be more interested in the particular product. Consumers may then have a larger attention span for such media because they anticipate the expected benefit.

Summary

Introduction to Part VIII: Networks, standards and systems

Information products and technologies are rarely used in isolation or just for their own sake. Take the example of instant messaging (IM) services, whose primary functionality is to allow you to exchange text messages with other users over the Internet in real time. The first IM services (like AOL Instant Messenger, Yahoo! Messenger or Windows Live Messenger) were used on computers and often bundled with a particular web browser. With the advent of smartphones, instant messaging became increasingly mobile and a number of IM applications (like Whatsapp, WeChat, Line, Viber, Kakao Talk, etc.) were made compatible with the major smartphone platforms (Android, iOS, BlackBerry, Windows Phone).

Regardless of the supporting technology, adopting a particular IM service involves for users a larger set of considerations than the purchase of, say, a bag of potatoes. In particular, a user of an IM service must care about what other users are doing. The benefits of using the service come, indeed, from two sources: first and foremost, the ability to chat with other users and potentially, the additional features that can be used within the IM application (such as editing pictures, recording down moments of your life, following accounts of celebrities or obtaining discounts from tied-up partners).

What is important to stress is that the benefits for an individual user increase with the number of other users of the service: either directly for the communication benefits (a larger base of users directly increases the number of potential contacts any user can have via the IM service), or indirectly for the benefits related to additional features (a larger base of users induces providers to supply more and/or better features to be combined with the IM service, which in turn raises the attractiveness of the service). We use the term network to describe the community of users whose benefits are made interdependent by the nature of the product they use. By analogy, we call goods like IM services network goods.

Summary

In this chapter, our goal is to examine the interplay between market structure and innovation. This is clearly a two-way relationship: on the one hand, firms’ incentives to invest in R&D depend on the structure of the product market they are acting in (i.e., on the number of rival firms and on the way they compete); on the other hand, firms are likely to use R&D to shape the structure of their market (e.g., by using R&D to increase their market share or to keep potential competition at bay). As the two effects are complex and intertwined, we simplify the analysis by assuming that firms can somehow appropriate the return from their R&D investments (we analyse how they actually manage to do so in the next chapter).We also break down the analysis into separate issues.

In Section 18.1, we assess how market structure affects the incentives for conducting R&D, which are measured by the profit increase that the innovator gains from the innovation. First, incentives to innovate are compared in the two market structures where strategic considerations are absent, namely monopoly and perfect competition. It is shown that the latter generates larger incentives to innovate than the former. Next, we extend the analysis to include strategic interaction by considering oligopolies. We reach an ambiguous result: a higher intensity of competition may increase or decrease the incentives to innovate depending on the initial starting point, the size of the innovation and the way competition is increased. Finally, we study the possibility for the innovator to obtain additional revenues by licensing its innovation to other firms, be it inside or outside its own industry.

In Section 18.2, we reverse our point of view by investigating how innovation may influence market structure. First, we reconsider a monopolist's incentives to innovate in situations where a competing firm threatens to enter the market. We show that the incumbent firm is often keener to invest in R&D than the entrant. Monopoly is thus likely to prevail over time, which indicates that innovation does indeed drive market structure. Second, we enrich the previous analysis by incorporating explicitly the time dimension. Indeed, a firm's main motivation when investing in R&D is often to be the first to come up with an innovation.

Summary

In the previous chapter, we have looked at advertising and prices as two strategic variables that might be used to overcome asymmetric information problems. In this chapter, we will look at additional instruments that belong to the toolbox of a firm, such as a car manufacturer, which is confronted with asymmetric information. We focus on two broad classes of instrument, namely warranties (in Section 13.1) and branding (in Section 13.2).

Warranties can be an effective tool to separate high- from low-quality products. A potential drawback is that consumers may not handle products with care if they hold a full warranty. This leads to a double moral hazard problem and makes this option possibly rather unattractive.

Branding is another important tool for producers of experience goods. It is an essential success factor for many companies since they want to be recognized over time and across products. Firms can then rely on their brand, which stems from repeated interaction over time and on the use of one brand for several products so that consumers can correlate their beliefs about product quality across products – this latter practice is known as umbrella branding. An additional insight is that competition may substantially affect the logic of branding.

Warranties

Warranties are an everyday feature of experience goods. For instance, cars, consumer electronics and appliances typically come with warranties. Warranties establish liability between the manufacturer and the buyer in the event that an item fails (i.e., if the item is unable to perform satisfactorily its intended function when properly used). Usually, the warranty contract specifies both the performance that is to be expected and the redress available to the buyer if a failure occurs. Warranties serve many purposes. These include protecting manufacturers and buyers, assuring buyers against items which do not perform as promised, and helping dispute resolution between buyer and manufacturer. To meet these objectives, public authorities have formulated legislation imposing minimal warranties.

Summary

In this chapter, we start by emphasizing the difference between menu pricing and group pricing (Section 9.1). We then provide a formal analysis of menu pricing by a monopolist. We derive the conditions under which menu pricing leads to higher profits than uniform pricing; we also perform the same analysis in terms of welfare (Section 9.2). Finally, we turn to the analysis of menu pricing in oligopolistic settings; we consider in turn quality- and quantity-based menu pricing (Section 9.3).

Menu pricing vs. group pricing

The previous chapter described situations where the sellers are able to infer their buyers’ willingness to pay from some observable and verifiable characteristics of those buyers (like age, gender, location, etc.). In many situations, however, there exists no such reliable indicator of the buyers’ willingness to pay. How much a consumer is willing to pay is their private information. The only way for a seller to extract more consumer surplus is then to bring the consumer to reveal this private information. To achieve this goal, the seller must offer his product under a number of ‘packages’ (i.e., some combinations of price and product characteristics). The key is to identify some dimensions of the product that are valued differently across consumers, and to design the product line so as to emphasize differences along those dimensions. The next step consists of pricing the different versions in such a way that consumers will sort themselves out by selecting the version that most appeals to them. Such practice is known as menu pricing, versioning, second-degree price discrimination or nonlinear pricing. A few examples are given in Case 9.1.

Case 9.1 Examples of menu pricing in the information economy

The dimension along which information goods are versioned is usually their quality, which is to be understood in a broad sense (for instance, the quality of software might be measured by its convenience, its flexibility of use, the performance of the user interface, etc.). For instance, ‘nagware’ is a form of shareware that is distributed freely but displays a screen encouraging users to pay a registration fee, or displaying ads. In this case, annoyance is used as a discriminating device: some users will be willing to pay to turn off the annoying screen.

Summary

Throughout the book, we have described a number of situations where firms might restrict competition in their attempt to increase their market power at the expense of their competitors and/or of consumers: collusive agreements in Chapter 14, welfare-reducing horizontal mergers in Chapter 15, predatory behaviour in Chapter 16 and exclusionary practices in Chapter 17. To assess whether such conduct is detrimental or not, we measured its effect on economic welfare. That allowed us to show that not all restrictions to competition are detrimental (think of the vertical restraints that we discussed in Chapter 17). But in the case they are, we were forced to recognize that market forces are not always sufficient to curb market power and reduce prices, implying that public intervention, namely competition policy, may be desirable.

Competition policy can be defined broadly (following Motta, 2004, p. 30) as ‘the set of policies and laws which ensure that competition in the marketplace is not restricted in such away as to reduce economic welfare’. In this appendix, our aim is to complement our previous analyses by giving a broad description of competition policy. We start by offering a brief historical perspective to understand where competition policy comes from (Section B.1). Then, focusing on the EU and the USA, we describe the relevant laws and link economic issues (exclusion, collusion, merger, etc.) to the particular laws (Section B.2). We proceed finally to a comparison of legal practice on both sides of the Atlantic. There exist important differences between the EU and the USA, but practices seem to converge nowadays (Section B.3).

A brief historical perspective

Competition policy was introduced in North America at the end of the nineteenth century and then spread across the rest of the world very gradually. Most European countries, as well as Japan, adopted competition policies in the mid-twentieth century. Other countries followed suit only recently in order to comply with regional agreements (such as the adhesion to the EU for Nordic and Eastern European countries) or with multilateral agreements (such as the membership of the WTO), or simply as part of a move towards a more market-oriented economic system (as was the case for a number of South-East Asian and Latin-American countries). To understand why some countries adopted competition policies earlier than others, it is useful to take a historical perspective.

Summary

Introduction to Part II: Market power

Firms are assumed to maximize profits but the market environment limits their abilities to exploit consumers. Indeed, if we can believe the perfectly competitive paradigm, firms will end up selling at a price equal to marginal costs. In particular, if firms are price-takers and small compared to the industry, they will not exert any market power.

But what happens if firms are not small compared to the industry they are operating in? This is certainly the case for heavyweights such as Coca Cola, Volkswagen Group, Samsung, ArcelorMittal, Gazprom, Anheuser-Bush InBev and the like. These large firms have seized a significant share of their respective markets. They can thus hardly be described as price-takers. Yet, as they face competition from a number of other firms, they cannot either be described as pure price-makers, like the monopolies we studied in the previous chapter. While these large firms undeniably exert market power, so do their smaller competitors. Market power – the ability to ‘make the price’ or to sell at prices above marginal costs – is thus collectively shared in those industries in which a few firms compete with one another. Such industries are called oligopolies (from the Greek ‘oligo’, which means ‘small number’). The vast majority of industries are oligopolies. The examples that spring to mind are the industries of these giant multinational firms that we mentioned above: soft drinks, cars, smartphones, steel, natural gas, beer, etc. But by simply looking around you, you will quickly realize that most of the goods and services you consume are produced, at least locally, by a small number of competing firms.

The distinctive feature of oligopolistic competition is that firms cannot ignore the behaviour of their competitors. Indeed, competitors do exist (this is not a monopoly) and they are not small (this is not perfect competition). It follows that firms’ profits ultimately depend on the combination of the decisions taken by all the firms in the industry. Hence, firms’ decisions cannot be optimal if they do not take this interdependence into account. Firms must incorporate in their decision-making the anticipation of how their competitors are likely to act, and to react to their own decisions. Oligopolistic competition is thus synonymous with strategic interaction.

Summary

In most markets for consumer goods, there do not exist identical products from the viewpoint of consumers. Even if physical properties are hardly distinguishable, branding may achieve that products are differentiated. A number of questions ensue on how to apprehend product differentiation. How do consumers perceive products and services? To what extent do different consumers share the same perceptions? How similar are the demand curves of various individuals? Do consumers care for variety? The answers to these questions, and hence the modelling choices of the analyst, depend on the nature of the products or services under consideration. Think for instance of the car market, which has been the object of a number of empirical studies. Here, the assumption that consumers buy a single car, but that the population of consumers has heterogeneous tastes, is a natural assumption to make. For other consumer goods, neither discrete choice nor unit demand are natural assumptions to make. If you think of beer or carbonated soft drinks, the discrete choice assumption is often an appropriate assumption to make but consumers not only differ in their brand preference but also in their individual demand curves. In the case of wine, we believe that neither unit demand nor discrete choice are good approximations of actual consumer behaviour and therefore, are bad modelling assumptions: a large share of consumers actually enjoy some variety and buy variable amounts of quantity.

In this chapter, we first address these questions by discussing some general approaches to differentiated products (Section 5.1). Then, we analyse discrete-choice models of horizontal and vertical product differentiation (respectively in Sections 5.2 and 5.3). In Section 5.2 we elaborate on the Hotelling model with linear and quadratic transportation costs, which have become standard workhorses in the industrial organization literature. The product positioning of a firm is guided by its attempt to provide a product that fits most tastes while avoiding competition from other firms by offering more specialized products. We elaborate on this trade-off. In Section 5.3 we focus on the observable quality choice by firms. Here, we add to our discussion of entry into product markets from Chapter 4 by showing that even negligible scale economies are sufficient for the property that only a small number of firms is viable in a market.

Summary

This chapter starts with a broad description of what network effects are: we distinguish between direct and indirect network effects, compare network effects to switching costs and report a number of empirical studies that have estimated the importance of network effects for various products (Section 20.1). We then proceed by characterizing demand and supply in network markets, looking first at a single good (Section 20.2) and next at several incompatible goods (Section 20.3). We will see that demand decisions may lead to multiple equilibria, leading to potential coordination problems, while supply decisions depend crucially on the level of compatibility between competing goods.

Network effects

Like instant messaging services, a large majority of information products and technologies exhibit network effects. Loosely defined, network effects refer to the idea that, other things being equal, it is better to be connected to a bigger network. In this section, we first make this idea more precise by distinguishing between direct and indirect network effects. We then draw the similarities and differences between network effects and switching costs. Finally, we provide some empirical evidence about the strength of network effects in various markets.

Direct and indirect network effects

Network effects can formally be defined as follows: a product is said to exhibit network effects if each user's utility is increasing in the number of other users of that product or of products compatible with it. Network effects are observed on two types of market.

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