Price regulation, network externality, and product innovation strategies: A dynamic analysis

For many high-tech and Internet-related products, consumers' utility depends partly on the scale of user groups, which is called network externality. This phenomenon plays a crucial role in shaping firms' innovation strategies, especially in markets with price regulation. This paper aims to investigate a monopolist's dynamic product innovation problem in a price-regulated market exhibiting network externality. We identify the sufficient conditions guaranteeing the existence of optimal steady-state equilibrium. Our analysis mainly shows the following: (i) the product quality and network size move in opposite directions along the path to the steady-state equilibrium; (ii) the equilibrium result of product innovation increases with the regulated price but decreases with the intensity of network externality; (iii) the social-welfare maximizing path of product innovation can be replicated by a dynamic price regulation regime, involving a premium on quality and a premium or a penalty on network size. Numerical experiments are performed to characterize the dynamic patterns of product innovation. We find that firms with high brand power prefer adopting mild product innovation strategy while for firms with low brand power, almost constant high-quality strategy is better.