When Do Markets Tip? A Cognitive Hierarchy Approach

Abstract

The market structure of platform competition is critically important to managers and policy makers. Network effects in these markets predict concentrated industry structures, whereas competitive effects and differentiation suggest the opposite. Standard theory offers little guidance — full rationality models have multiple equilibria with wildly varying market concentration. We relax full rationality in favor of a boundedly rational cognitive hierarchy model. Even small departures from full rationality allow sharp predictions — there is a unique equilibrium in every case. When participants single-home and platforms are vertically differentiated, a single dominant platform emerges. Multihoming can give rise to a strong–weak market structure: one platform is accessed by all, and the other is used as a backup by some agents. Horizontal differentiation, in contrast, leads to fragmentation. Differentiation, rather than competitive effects, mainly determines market structure.

Keywords: platform competition, bounded rationality, cognitive hierarchy, vertical and horizontal differentiation