The welfare effect of quality degradation in the presence of network externalities

This paper examines how the presence of network externalities affects a monopolist’s incentive for quality degradation and its welfare consequence. The software and the Internet service industries provide our primary motivation. The network externality may lead to a Pareto-improving quality degradation that would not be realised in the absence of network externalities. However, it may also overturn a potentially Paretoimproving quality degradation to a welfare-reducing one, or result in the realisation of a welfare-reducing quality degradation that would be avoided without network externalities. We also endogenise the firm’s forward and backward compatibility decisions between the original good and the degraded good.