Boundaries of the Firm with Network Externalities

Abstract

We examine that each manufacturer decides on whether or not to delegate to its retailer in the presence of network externalities. In this paper, we show a trade-off between competition and network size. Vertical separation has the advantage of softening a retailing competition, but has the disadvantage of downsizing a network size. On the other hand, vertical integration has advantage of increasing the network size, but has disadvantage of intensifying the retailing competition. In these circumstances, network effect and competition play important roles in equilibrium. Our conclusion differs sharply from the conventional results in two points. One is that it is a dominant strategy for each manufacturer to choose vertical integration if competition effect is overwhelmed by network effect. The other is that if network effect is strong, profits, consumer surplus, and social welfare are higher under vertical integration than separation.