Vertical Differentiation, Social Networks and Compatibility Decisions

This paper considers a vertical differentiation model with positive network effects. It is based on the assumption that consumers belong to the same network if they buy products exhibiting close characteristics. Thus, the network has two characteristics: its intensity and its selectivity. The higher the network intensity, the more positively affected the consumer is by the network size. The network selectivity corresponds to how close the products' characteristics should be to be perceived by consumers as compatible. The closer two compatible products are in the product space, the more selective the network.We analyze the strategic behavior in terms of prices and qualities of two firms: an incumbent and a potential entrant. By choosing its quality the entrant chooses at the same time to be compatible or not.We show that if the network intensity is moderate, it is always profitable for the entrant to enter the market. In this case the entrant is compatible with the incumbent when the network is not very selective and is incompatible when the network is selective. If the network intensity is strong, we prove that it acts as a barrier to entry under incompatibility. The equilibrium outcomes in this case are either no entry or compatible.