Networks Effects, Nonlinear Pricing and Entry Deterrence

A number of technology products display positive network effects, and are used invariable quantities by heterogeneous customers. Examples include operating systems, infrastructureand back-end software, web services and networking equipment. This paper studies optimalnonlinear pricing for such products, under incomplete information, and with the threat of competitiveentry. Both homogeneous and heterogeneous network effects are modeled. Conditions underwhich a fulfilled-expectations contract exists and is unique are established. While network effectsgenerally raise price, it is shown that accompanying changes in consumption depend on the natureof the network effects - in some cases, it is optimal for the monopolist to induce no changes in usageacross customers, while in others cases, network effects raise the usage of all market participants.Optimal pricing is shown to include quantity discounts that increase with usage, and may also involvea nonlinear two-part tariff. These results highlight the impact of network effects on trade-offsbetween price discrimination and value creation, and have important managerial implications forpricing policy in technology markets.The need to deter competitive entry generally lowers profits for the monopolist, and increasescustomer surplus. When network effects are homogeneous across customers, the resulting entry-deterringmonopoly contract is a fixed fee and results in the socially optimal outcome. However,when the magnitude of heterogeneous network effects is relatively high, there are no changes intotal surplus induced by the entry threat, and the price changes merely cause a transfer of valuefrom the seller to its customers. The presence of network effects, and of a credible entry threat, arealso shown to increase distributional efficiency by reducing the disparity in relative value capturedby different customer types. Regulatory and policy implications of these results are discussed