Internet Exchange Formation and Competition When Potential Participants Can Coordinate

Abstract

We analyze the formation and competition of market intermediaries when there are positive participation externalities between the two sides of the market; negative participation externalities within the same side; competition with traditional market; and implicit coordination among potential participants. The impact of implicit coordination is studied in two ways. First, we develop both static models - which are appropriate when the number of potential participants is large - and dynamic models - which are appropriate when a limited number of participants observe each other's choices. Potential participants can better coordinate their decisions in the dynamic participation process. Second, we assume that participation decisions are coordinated by a pessimistic belief about formation or entry of a new intermediary. In order to overcome the pessimism, the owner of an intermediary has to offer a fee schedule that implements her preferred outcome as the unique (subgame-perfect) Nash equilibrium outcome. The theory explains when and in which direction cross-subsidization strategies appear and when the incumbent intermediary can deter entry profitably.