Intergration between Hardware an d Software Producers in the Presence of Indirect Network Externalities

This paper aims to analyze the effects of the integration between hardware and software producers in the presence of indirect network externalities. Even without this integration, a hardware producer can subsidize independent software producers for the provision of more software products. The integration, however, may facilitate the integrated firm to coordinate for the development of software products, giving the integrated firm a first-mover advantage in the subsidization for software development. To highlight this first-mover advantage of the integrated firm, we posit a situation in which there exist an integrated (incumbent) hardware/software firm and an un-integrated (entering) hardware firm. With this first-mover advantage, the incumbent can choose either to accommodate or to deter the entry by enhancing the applications barrier to entry. Extending the model of Katz and Shapiro (1985), we will show that the accommodation equilibrium is always socially more beneficial (in terms of consumer surplus) than the duopoly equilibrium with the breakup of the incumbent. Furthermore, the deterrence equilibrium can be socially more beneficial as well if the entrant’s fixed start-up cost is sufficiently low.