The Stackelberg Model as a Partial Solution to the Problem of Pricing in a Network

We consider an application of the Stackelberg leader-follower model in prices in a simple two-firm network as a possible way to help resolve externalities that can be harmful to firm profit and welfare. Whilst independent pricing on the network yields lower profit and sometimes even lower welfare than monopoly pricing, we show that by allowing the firms to collude on some prices in a first-stage and set remaining prices independently (competitively) in a second stage, both profit and welfare gains can be made.