Switching cost, network externality and platform competition

Abstract

With the presence of both switching cost and network externality, this paper builds a two-stage model for competition between two platforms. In stage one, an incumbent platform controls the market as a monopolist and sets a price to acquire a user base. In stage two, a new platform enters the market to compete against the incumbent. We consider a non-strategic competitor with a free product in the benchmark model and also extend the model to allow for a strategic competitor. Our main results show: (1) When the switching cost is relatively high and the network externality is relatively low, the first mover adopts a closed strategy by maintaining a high price in stage two and harvesting profits from its original users. (2) When the switching cost is relatively low and the network externality is relatively high, the first mover adopts an open strategy by setting a low price to acquire more users in stage two, and the first-mover advantage based on the presence of switching cost will become ineffective. Our work rationalizes the coexistence of high competition and high concentration in a market with strong network externality, and thus provides a reasonable explanation for the existing paradox: even though the internet industry is much more competitive than traditional industries, the concentration level of internet industry is still higher than that of traditional industries.