Pricing of Complementary Goods and Network Effects

Nicholas Economides, Stern School of Business, New York University
V. Brian Viard, Cheung Kong Graduate School of Business (CKGSB), Beijing, China

Abstract

This study examines a monopolist of a base good that benefits from a complementary good provided by either it or another firm. Use of the complementary good requires the base good, but not the reverse. The model assesses and calibrates the extent of the positive influence on the base good profits that is created by the existence of the two sources (internal or external) of the complementary good. An equivalence between a model of a base and complementary good, and a reduced-form model of the base good where network effects are assumed in the utility function as a surrogate for the presence of direct network effects (i.e., a consumer’s utility directly increases in the number of users) or indirect network effects (i.e., arising from increased variety of complementary goods produced by other firms) is established. This allows us to examine the pricing of the complementary good under different market structures and in the context of the effect of other complementary goods via the network effects. Additionally, the study assesses and calibrates the influence of the intensity of network effects and quality improvements in the complementary good on profits from the base good. Also evaluated is the incentive that a monopolist has to improve the quality of the base good rather than that of a complementary good that it produces.