Two-Sided Network Effects: A Theory of Information Product Design

How can firms profitably give away free products? This paper provides a novel answer and articulates tradeoffs in a space of information product design. We introduce a formal model of two-sided network externalities based in textbook economics—a mix of Katz & Shapiro network effects, price discrimination, and product differentiation. Externality-based complements, however, exploit a different mechanism than either tying or lock-in even as they help to explain many recent strategies such as those of firms selling operating systems, Internet browsers, games, music, and video. The model presented here argues for three simple but useful results. First, even in the absence of competition, a firm can rationally invest in a product it intends to give away into perpetuity. Second, we identify distinct markets for content providers and end consumers and show that either can be a candidate for a free good. Third, product coupling across markets can increase consumer welfare even as it increases firm profits. The model also generates testable hypotheses on the size and direction of network effects while offering insights to regulators seeking to apply antitrust law to network markets. ACKNOWLEDGMENTS: We are grateful to participants of the 1999 Workshop on Information Systems and Economics, the 2000 Association for Computing Machinery SIG E-Commerce, the 2000 International Conference on Information Systems, the 2002 Stanford Institute for Theoretical Economics (SITE) workshop on Internet Economics, the 2003 Insitut D’Economie Industrielle second conference on “The Economics of the Software and Internet Industries,” as well as numerous participants at university seminars. We wish to thank Tom Noe for helpful observations on oligopoly markets, Lones Smith, Kai-Uwe Kuhn, and Jovan Grahovac for corrections and model generalizations, Jeff MacKie-Mason for valuable feedback on model design and bundling, and Hal Varian for helpful comments on firm strategy and model implications. Frank Fisher provided helpful advice on and knowledge of the Microsoft trial. Jean Tirole provided useful suggestions and examples, particularly in regard to credit card markets. Paul Resnick proposed the descriptive term “internetwork” externality to describe two-sided network externalities. Tom Eisenmann provided useful feedback and examples. We also thank Robert Gazzale, Moti Levi, and Craig Newmark for their many helpful observations. This research has been supported by NSF Career Award #IIS 9876233. For an earlier version of the paper that also addresses bundling and competition, please see “Information Complements, Substitutes, and Strategic Product Design,” November 2000, http://ssrn.com/abstract=249585.