Price Discrimination and the Hold-Up Problem: A Contribution to the Net-Neutrality Debate

This paper studies ex-ante investment incentives of a buyer (a content provider) facing a monopoly input seller (an internet service provider), who employs second-degree price discrimination. As a benchmark, we extend an adverse-selection model by a noncontractible investment stage, which allows the buyer to improve her type. The buyer underinvests due to partial rent extraction by the seller. When the buyer uses the seller’s product as an input in a downstream production process, and the seller also charges downstream customers of the buyer, the seller faces a two-sided market. We show that the underinvestment problem in the two-sided setting is less severe compared to the onesided market, because the seller cross-subsidizes the content provider in order to extract more rent from downstream customers. When we introduce competition, this result is reversed: first-best investment can be achieved in the one-sided case, while even fierce competition can leave investment incentives unchanged in the two-sided setting. Finally, we provide conditions under which a net-neutrality regulation (no charges for the buyer) can alleviate the hold-up problem and demonstrate that net neutrality might even arise endogenously.