Two-Sided Network Effects: A Theory of Information Product Design

Abstract

How can firms profitably give away free products? This paper provides a novel answer and articulates trade-offs in a space of information product design. We introduce a formal model of two-sided network externalities based in textbook economics---a mix of Katz and Shapiro network effects, price discrimination, and product differentiation. Externality-based complements, however, exploit a different mechanism than either tying or lock-in even as they help to explain many recent strategies such as those of firms selling operating systems, Internet browsers, games, music, and video. The model presented here argues for three simple but useful results. First, even in the absence of competition, a firm can rationally invest in a product it intends to give away into perpetuity. Second, we identify distinct markets for content providers and end consumers and show that either can be a candidate for a free good. Third, product coupling across markets can increase consumer welfare even as it increases firm profits. The model also generates testable hypotheses on the size and direction of network effects while offering insights to regulators seeking to apply antitrust law to network markets.network effects, network externalities, two-sided markets, free information, business models, strategic complements, product design

Platform Architecture and Quality Trade-offs of Multihoming Complements

“…Much of the literature on multihoming draws on the broader literature on two-sided (or platform) markets (McIntyre andSrinivasan 2017, Parker andVan Alstyne 2005) to explain the dynamics of platforms and their complementary products. Early theoretical studies (Armstrong 2006;Armstrong and Wright 2007;Caillaud and Jullien 2003;Rochet and Tirole 2003) focus on which side multihomes and who takes most of the surplus.…”

“…Platform technologies such as Apple's iPhone, Microsoft's Xbox, or SAP Netweaver are increasingly common as the infrastructure for transactions between producers, like providers of complements, and consumers (Hagiu and Wright 2015, Parker and Van Alstyne 2005, Rochet and Tirole, 2006. While consumers mostly tend to prefer one platform, 1 complement providers increasingly "multihome"-that is, they develop products for multiple platforms, aiming to reach as many potential consumers as possible (Bresnahan et al2015, Corts andLederman 2009).…”

Dynamic Pricing in Management Science

“…This point is all the more important if the product's use is linked to the presence of other goods. Consumers prefer a good which is more likely to obtain additional benefits when associated with content such as manuals, books, or extensions of qualified staff (Parker and Van Alstyne, 2005). Thirdly, existing consumers form expectations about the future size of a network.…”

“…This is a fundamental difference with conventional markets. The concept of mindshare is used to describe consumers' knowledge of a product and to assess future success (Parker and Van Alstyne, 2005). It partly figures the expectations of consumers on the future deployment of a product.…”

Business ecosystem research agenda: more dynamic, more embedded, and more internationalized

“…That is, the value of a product/service increases in line with the number of people that use it. This indicates a two-sided market to explain the network effect in platform-based business competition: the focal firm will earn more benefits if its platform is home to more users, from both supply and demand sides (Katz and Shapiro 1994;Parker and Van Alstyne 2005;Tirole 2003, 2006;Shankar and Bayus 2003). For instance, in the ICT (Information Communications Technology) industry the more complementors join the ecosystem to supply complementarities, the more valuable the platform becomes to consumers due to a greater variety of choice (Scholten and Scholten 2012).…”