Network externalities and the overprovision of quality by a monopolist

We investigate the behavior of a monopolist supplying a vertically differentiated good with network externalities. Assuming a convex unit cost of quality improvements, we show that the presence of network externalities may yield oversupply of quality compared with the social optimum, when partial market coverage emerges at equilibrium. Overall, the incentive to expand output increases in the extent of network externalities, thereby partially counterbalancing the social damage produced by the quality distortion.

1. Introduction

The increasing relevance of high-tech sectors, such as telecommunication, hardware-software, and audio-video industries, justifies the growing amount of attention devoted to the analysis of markets for goods that generate network externalities (Katz and Shapiro 1985, 1986, 1994; Farrell and Saloner 1985, 1986). An example taken by the audio-video industry is the current discussion concerning the possibility of adopting a new standard for hi-fi equipments, DVD (digital versatile disc) or SACD (super audio compact disc). The network effect consists of the fact that the utility from purchasing equipment characterized by a given standard is positively related to the number of consumers who purchase a compatible equipment, for two reasons. The first is that the larger the number of users of a given standard, the wider the range of software made available for that standard. The second is that a larger network of users is usually associated with more efficient customer service and technical assistance.

The foregoing analysis has some relevant policy implications. When the market is sufficiently poor to induce even a benevolent planner to exclude some individuals from consumption, both the welfare distortion and the related incentive to regulate the monopolist are nonmonotone in the extent of network effects. This nonmonotonicity disappears as soon as full market coverage emerges at equilibrium under social planning, as in this situation the welfare loss is constant. Since network effects enhance the incentive to serve all consumers, the above argument holds that a large network effect tends to eliminate output distortions and leave in operation quality distortions only, the latter being less harmful than the former in most cases.

Received April 2000; accepted August 2000.

1 Second-order conditions are met throughout the calculations performed in the paper, although not shown for the sake of brevity.

2 As t tends to zero, the optimal monopoly quality would tend to infinity. Actually, the monopolist would produce the maximum quality that is technologically feasible, q,. The resulting output is lower than 1, and pmc obtains, for all a Epsilon [0, (q^sub max^)/2). It is easy to verify that, when production costs are nil, the social planner supplies all consumers with q^sub max^ for all alpha >=O.

I Observe that min II^sub M^ = I/(27t) at (alpha = 0, theta = 1. Therefore, if we considered a fixed cost F, we should assume F =

1/(27t) to fully preserve the validity of the analysis and avoid considering the break-even condition.

4 Notice that this result can be sensitive to the specification of the cost function. If quality improvements hinge upon research and development activity whose costs are unrelated to output, the incentive to oversupply quality may disappear.

5To the northeast of curve B, quality is always undersupplied at the monopoly equibrium.

6In the range of theta where the deadweight loss is nonmonotone with respect to alpha, the interval whereindelta(SWsP - SWM)/ delta,alpha > 0 shrinks as t, that is, marginal production cost, increases. This is due to the incentive, for both the planner and the monopolist, to induce more consumers to buy, by exploiting the network effect rather than the hedonic effect. This is accomplished by raising the output level rather than the quality level.

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