Strong Network Effects Eliminate Spence Distortions

Strong network effects generate multiple tipping equilibria, in which firms compete for the adoption of all consumers rather than the marginal consumer. In this scenario, a quality distortion—the Spence distortion—should be absent; this contradicts the well-established Spence distortion results in the literature on network economics. This inconsistency stems from the choice of equilibrium selection criterion. This paper shows that all popular selection criteria in that literature lead to Spence distortions, whereas risk dominance and its generalizations do not. This suggests that network market regulations based on Spence distortion arguments may be misguided