Interconnection Incentives of a Large Network

This paper builds on Cremer, Rey and Tirole’s analysis of the possible incentives of a firm with the largest share of installed-base customers, in a market characterized by strong network externalities, to degrade or refuse interconnection with its smaller rivals in order to gain a relative quality advantage in competing for new customers. We extend their model to allow any number of smaller rivals. We show that degrading interconnection can lead to tipping of the market away from the largest network even if its share of the installed base exceeds one half; for a given initial share of the largest network, such tipping becomes more likely as the number of rivals increases. We examine the minimal market share required for the largest network to prefer degradation (considering both tipping and non-tipping equilibria), as a function of the model’s key parameters. Besides the number of rivals, key parameters include firms’ common marginal cost and the size of the installed-base relative to potential additional demand. Lower values of these parameters make profitable degradation less likely. In the case of the Internet, plausible parameter values suggest that degradation is not likely to be profitable unless the largest network commands significantly more than fifty percent of the installed customer base. JEL: L13, L41, L86, L96