Tipping and Concentration in Markets with Indirect Network Effects

TLDR

This paper develops a framework for measuring “tipping”—the increase in a firm’s market share dominance caused by indirect network effects. The authors construct a counterfactual model of dynamic standards competition—using a hardware/software paradigm and calibrated with 32/64‑bit video game console data—to compare expected market concentration with and without indirect network effects. The analysis shows that indirect network effects can substantially raise market concentration, with consumer expectations and firms’ penetration‑pricing strategies playing key roles.

Abstract

This paper develops a framework for measuring “tipping”—the increase in a firm's market share dominance caused by indirect network effects. Our measure compares the expected concentration in a market to the hypothetical expected concentration that would arise in the absence of indirect network effects. In practice, this measure requires a model that can predict the counterfactual market concentration under different parameter values capturing the strength of indirect network effects. We build such a model for the case of dynamic standards competition in a market characterized by the classic hardware/software paradigm. To demonstrate its applicability, we calibrate it using demand estimates and other data from the 32/64-bit generation of video game consoles, a canonical example of standards competition with indirect network effects. In our example, we find that indirect network effects can lead to a strong, economically significant increase in market concentration. We also find important roles for beliefs on both the demand side, as consumers tend to pick the product they expect to win the standards war, and on the supply side, as firms engage in penetration pricing to invest in growing their networks.