Market Entry and Competition Under Network Effects

• Published in: Operations research 2024-11, Vol.72 (6), p.2467-2487
• Main Authors: Feng, Yinbo, Hu, Ming
• Format: Article
• Language: English
• Subjects: Budgets; buyer behavior; Competition; competitive strategy; Consumer behavior; Decision making; Decisions; Equilibrium; Market Analytics and Revenue Management; marketing; Markets; Neural networks; probability; Sales; stochastic model applications; Strategy
• ISSN: 0030-364X; 1526-5463
• DOI: 10.1287/opre.2022.0275

The “long tail” theory was celebrated by BusinessWeek as the biggest idea of the year 2004, soon after the book The Long Tail by Chris Anderson was published. The long tail theory calls for applying a low-budget strategy—producing a (relatively) large number of products with (relatively) low investment levels. However, some other cultural industries may tell a different story. The concentration of the most popular titles in the video game industry is growing, a phenomenon known as the blockbuster phenomenon. This phenomenon suggests that firms may adopt a high-budget strategy—producing a (relatively) small number of products with (relatively) high investment levels. In “Market Entry and Competition Under Network Effects,” Y. Feng and M. Hu analytically study the impact of a network effect on entry decisions and investment strategies (i.e., the high-budget versus low-budget strategies) adopted by competing firms based on which they further provide a theory that links the ex post sales volume concentration with the ex ante product variety in a market under network effects. We consider a three-stage game in which, first, a large number of potential firms make entry decisions, then those who choose to stay in the market decide on the investment (quality) level in each product, and last, customers with heterogeneous preferences arrive sequentially to make (random) purchase decisions based on product quality and historical sales under the network effect according to a discrete choice model. We characterize such a random purchase process and show that a growing network effect always contributes to more sales concentration ex post on a small number of products. Perhaps surprisingly, we further show several phase-changing phenomena regarding equilibrium outcomes with respect to the network effect’s strength. In particular, the equilibrium product variety (respectively, quality investment) first decreases (respectively, increases) and then increases (respectively, decreases) as the network effect grows. Specifically, when the strength of the network effect is below a threshold, an increasing network effect would shift more sales toward those products with higher quality, preventing more products from entering the market ex ante and inducing firms to adopt the high-budget equilibrium strategy by making a small number of high-quality products, which is consistent with the blockbuster phenomenon. When the strength of the network effect is above the threshold, the netwo