Quality Enhancing Network Effect and Endogenous Market Structure

In many digital products markets, network externality plays an important role to affect the overall quality of the product. However, the parameter which measures the strength or the degree of demand network externality is assumed to be fixed in most of the literature. We propose a model of vertical product differentiation with two competing firms where the strength of the network externality is endogenized as a strategic choice of the high quality firm. This leads to interesting market structures and market coverage in the equilibrium. We find that whether the market will be partially or fully covered and whether the resulting market structure will be monopoly or duopoly come out endogenously in the model. The equilibrium outcomes depend on how costly the investment on the network externality is and the relative difference in respective qualities of the products. In the comparative statics analysis the relation between the optimal degree of network externalities and the relative quality differences of the products is studied for various levels of costliness of investment on the network externality by the high quality firm.