Working Paper: CEPR ID: DP16783
Authors: Robert Akerlof; Richard Holden; Luis Rayo
Abstract: Many of the largest publicly traded companies--for example, Amazon, Google, and Facebook--operate in "new economy" markets with large network externalities where demand need not be downward sloping and there can be multiple equilibria in demand. Modeling these increasingly important--but not yet fully understood--markets requires taking a stance on the shape of the demand curve and on when firms will be "in" or "out." In an attempt to make further progress, we propose a framework with an intuitively-appealing demand curve (which we micro-found) and a new focality concept, based upon level-k thinking, that is both tractable and flexible enough to accommodate heterogeneous consumers.Under this focality concept, consumers' "impulses"--or level-0 thinking--determine the level of demand. We show that firms may compete for the market itself rather than for the marginal consumer, and that a novel form of limit pricing arises in this case. We characterize how competition changes with firms' technologies, consumers' impulses, and the strength of network externalities, and discuss how our theory informs debates on regulation of the new economy.
Keywords: network externalities; price competition; market dominance
JEL Codes: D40; L10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Consumer impulses (D12) | Firms compete for the market (L13) |
| Firms compete for the market (L13) | Alters traditional competitive dynamics (D43) |
| Improvements in dominant firm's technology (L15) | Increase dominant firm's profits (L21) |
| Improvements in nondominant firm's technology (O39) | Increase consumer surplus (D11) |
| Change in consumer impulses favoring dominant firm (D43) | Higher prices (D49) |
| Change in consumer impulses favoring dominant firm (D43) | Lower consumer surplus (D11) |
| Change in consumer impulses favoring dominant firm (D43) | Lower total surplus (D69) |
| Increase in network externalities (D85) | Strengthen competition (L49) |
| Increase in network externalities (D85) | Reduce prices (when consumer impulses favor nondominant firm) (D43) |
| Increase in network externalities (D85) | Increase prices (when consumer impulses favor dominant firm) (D43) |