Product Line Design in Markets with Network Externalities

Abstract

The extant economic and marketing literature on product line design mainly addresses firm's product decisions in conventional markets. However, many products demonstrate salient network externalities in their consumption, such as computers, software, telephone, telefax, and Internet routers. To our best knowledge, the role of network externalities in product line design has not been addressed. This paper fills the gap by investigating how the optimal structure and prices of a product line depend on the network externalities in the product market. A fundamental insight we obtain is that, in markets with network effects, the firm has a greater incentive to extend the length (as measured by the number of product varieties) of its product line. In our vertical model, market segmentation is sub-optimal in the absence of network externality. With externality, the monopolist offers two distinct products demonstrating maximum differentiation. The low-end product is used primarily to expand the product network, and is offered below marginal cost when externalities are sufficiently strong.

Keywords: Product Line Design,Market Segmentation,Network Externality,Price Discrimination,Vertical Differentiation

JEL Classification: L12, L15, L63