DP16783 Network Externalities and Market Dominance
Many of the largest publicly traded companies--for example, Amazon, Google, and Facebook--operate in "new economy" markets with large network externalities where demand need not be downward sloping and there can be multiple equilibria in demand. Modeling these increasingly important--but not yet fully understood--markets requires taking a stance on the shape of the demand curve and on when firms will be "in" or "out." In an attempt to make further progress, we propose a framework with an intuitively-appealing demand curve (which we micro-found) and a new focality concept, based upon level-k thinking, that is both tractable and flexible enough to accommodate heterogeneous consumers.
Under this focality concept, consumers' "impulses"--or level-0 thinking--determine the level of demand. We show that firms may compete for the market itself rather than for the marginal consumer, and that a novel form of limit pricing arises in this case. We characterize how competition changes with firms' technologies, consumers' impulses, and the strength of network externalities, and discuss how our theory informs debates on regulation of the new economy.