Bertrand Competition in Markets with Network Effects and Switching Costs

Abstract

Abstract We analyze Bertrand duopoly competition in markets with network effects and consumer switching costs. Depending on the ratio of switching costs to network effects, our model generates four different market patterns: monopolization and market sharing, which can be either preserved or reversed. A critical mass effect where one firm becomes the monopolist for sure only occurs for intermediate values of the ratio, whereas for large switching costs market sharing is the unique equilibrium. For large network effects, both monopoly and market sharing equilibria exist. Our welfare analysis reveals a conflict between maximization of consumer surplus and social welfare when network effects are large. We also analyze firms’ incentives for compatibility and incentives to increase switching costs and examine how market outcomes are affected by market expansion and cost asymmetries. Finally, in a dynamic extension of our model, we show how competition depends on agents’ discount factors.