Imperfect Competition in Internet Markets: The Role of Network Effects in Determining Market Structure

In this paper, we analyze how network effects are an important factor that determine market structure and the results observed in Internet markets. As we mentioned before, the general perception is that the Internet opened the gates for a new era of more competitive markets. However, we found that specific characteristics of the network in which markets operates in the Internet do not necessarily enhance market competition. In order to understand how markets function under network effects, first, we develop a model of investment and market competition. Proceeding differently from usual economic models, we assume that many firms compete in a first period of investment, and they then interact in a second period of market competition. By assuming a competitive ex ante environment, we are taking into account the main characteristic of the Internet, i.e., the open access of the network. During the second period, we observe that the number of competitors shrink and market structure becomes more concentrated. Because of our interest in Internet markets, we assume the network is completely accessible to any firm, i.e., the network is not controlled by anybody but rather is open to competition. Furthermore, since market share is important for controlling the market and the network, we assume that firms behave strategically, i.e., each firm takes into account other firms’ possible behavior in order to decide their best investment choice. Based on this general model, we find that firms’ optimal strategy is to behave aggressively in investing to develop new technologies that enable them to control the market. Furthermore, we find that those firms that are not willing to invest aggressively are quickly driven out of the market. Furthermore, after the investment period, during the market competition period, firms will try to control the market and establish a secure network. In this stage, many firms are put out of business and just a few competitors are left. In this model, we also assume the existence of two types of technologies, compatible and incompatible ones. As we demonstrate, the election of any of these two particular technologies will depend on the level of market control that any given firm expects to have. In order to study this model in more detail, we develop the model for the case of two firms, a monopoly and a benevolent dictator. We find that the level of investment is higher in the case of competition and the benefits are higher under a monopoly. Accordingly, this constitutes an incentive for firms to try to control the market by investing strongly in the first period and to then reap monopoly profits. Based on the general results from our model, we develop a series of implications for markets in the Internet environment. First, the competition generated by strong network effects produces a race to win the market and eliminate other competitors. Hence, markets are not stable but in continuous change induced by strategic competition and elimination among firms. Second, even in markets with low entry costs, new firms have important barriers to entry. Third, firms will develop different strategies to control markets and decrease competition. Finally, market concentration is the natural consequence derived from this kind of market and from the incentives that firms face. Lastly, we develop a case study in order to analyze how competition takes place in software markets for the Internet. We show that our model consistently explains the behavior of firms behavior in this context.