Quality Competition and Market-Share Leadership in Network Industries

Abstract

This paper incorporates network externalities into a model of vertical product differentiation to examine how firms determine product quality and network size. We show that, with significant network benefits from quality improvement, the effects of network externalities differ depending on the type of competition. In response to an increase in network externalities, vertical product differentiation enlarges under price competition but shrinks under quantity competition. Moreover, under price competition, the network size of a high-quality product increases, whereas that of a low-quality product decreases for a sufficiently large extent of network externalities, resulting in a reversal in the leading position in terms of network size from the low- to the high-quality product. By contrast, the network sizes of high- and low-quality products both increase under quantity competition; moreover, the gap between their network sizes shrinks for a sufficiently large extent of network externalities.

Network externalities in a quantity-setting vertically differentiated luxury goods market

“…Lambertini and Orsini (2005) derived the existence of a pure-strategy subgame-perfect equilibrium in qualities and prices in a duopoly model with vertical differentiation where quality improvements require a quadratic variable cost and network externalities operate. Cheng and Chan (2023) showed that, with significant network benefits obtained from quality enhancement, the effects of network externalities differ in response to the type of competition by examining how firms determine their vertical product quality and network size. Grilo et al (2001) showed that consumer vanity reduces price competition, whereas weak conformity intensifies competition by taking not only positive network effects but also negative effects under the spatial model of product differentiation.…”

Product quality, network effects, and efficiency of network markets

“…Their results show that product quality has greater impacts on market share than do network effects, which means that network markets are particularly efficient. Many researchers have commented, made rejoinders and raised a variety of questions and implications about this compelling finding ( Brown and Morgan, 2009 ; Ratchford, 2009 ; Reibstein, 2009 ; Rossi, 2009 ; Shugan, 2009 ; Hu and Mcloughlin, 2012 ; Kim et al, 2014 ; Hilbolling et al, 2021 ; Cheng and Chan, 2022 ). These researchers agree that product quality and network effects have important impacts on market share, but disagree about product quality being able to overcome the influence of network effects and lead to an inefficient market.…”

“…These researchers agree that product quality and network effects have important impacts on market share, but disagree about product quality being able to overcome the influence of network effects and lead to an inefficient market. They point out that the findings regarding product quality’s dominating network effects on market share may be biased upward or downward because of excluded variables, such as price ( Hilbolling et al, 2021 ), brand ( Ratchford, 2009 ), advertisement ( Reibstein, 2009 ), and customer uncertainty ( Cheng and Chan, 2022 ). Findings and conclusions of Tellis et al (2009) lack of theoretical grounds on the causality, cannot explain such examples as the dominance of Coca Cola over Pepsi, even though there is no apparent difference in product quality between them.…”