Strategic Investment in Networks

We examine how the presence of network effects influences investment decisions. Building a network requires significant upfront investment but benefits carry tremendous uncertainty. This creates an incentive to defer the commitment of irreversible investments. However, such investments may also create the opportunity to convince the consumers about the network’s size, establish a network standard, and preempt future competitors. Our models account for the tradeoff between these countervailing forces to obtain the investment rules for building networks. First, we study the investment decision faced by a monopolist in both the investment opportunity and product market. By investing prior to the resolution of uncertainty, the monopolist convinces the consumers of the network size. We solve for the threshold level of expected demand which must be exceeded in order to commit the investment. This threshold is lowered by an increase in the intensity of the network effect but the effect of uncertainty on the investment threshold is ambiguous. Our second model allows for future competitor entry where the entrant may either adopt the monopolist’s standard or build its own network. We find that the optimal licensing fee may be lower than the highest level that the entrant would accept. When future competition is anticipated, the investment threshold is monotonically decreasing in both the intensity of network effects and the level of uncertainty. * We would like to thank John Henderson, George Wyner, Chi-Hyon Lee, Kathleen Curley and other participants at the IS seminar series at Boston University for their insightful comments. Funding was provided by the Boston University Institute for Leading in a Dynamic Economy. All errors and omissions are ours.