The Impact of Competition on Pricing in a Two-sided Market

Abstract

Today, many high-tech products function as intermediaries in two-sided markets and a thorough understanding of the distinguished market mechanism is considered to be a key to success. The hardware manufacturers battle for getting the initial advantage, reinforcing their own networks and ultimately dominating the market. Although an extensive empirical research focuses on the relationship between competition and indirect network effects, accounting for market dominance due to the unique price mechanism, little empirical studies have addressed the extent to which the distinguished price structure in two-sided markets depends on the market structure among platforms. The reverse causality of the commonly investigated relationship in durable goods industry is a particularly interesting avenue for research. This paper develops an empirical model to investigate the impact of competition on optimal pricing of durable products under indirect network effects by extending the framework in Dubé, Hitsch and Chintagunta(2010). This study differs from theirs in the following ways: First, I modify the framework in the supply side to incorporate the hypothetical market structure (i.e. monopoly) as well as the observed market structure (i.e. oligopoly). Second, they focus on the endogenous market dominance of one platform whereas my analysis explains the impact of exogenously determined market structure. I estimate demand that accounts for consumers' forward-looking behaviors and solve for the Markov Perfect Nash Equilibrium through numerical dynamic programming techniques. The research entails comparing the expected price in the oligopoly market to the hypothetical expected price in the absence of competition and examines the impact of exogenously determined competition among intermediaries. The monopoly case consists of two scenarios: 1) one of the existing firms in the oligopoly market produces and sells a single product and 2) the existing firms are merged into one firm which offers several kinds of hardware products at different prices. This research investigates the second scenario and compares the price levels in oligopoly market to those in monopoly market. I apply my model to the U.S. video game console market, a canonical example of a two-sided market. The empirical estimation and simulation results indicate that the manufacturers price skim over time regardless of market structure. The price level differentiates the two markets. The merged firm sets higher prices by 12.6% for Sony PlayStation and by 14.1% for Nintendo 64 on average than the different firms do for their single platforms respectively since the merged firm does not get engaged in the standard war. The measure of difference between the price levels reveals the impact of exogenously determined competition on two-sided dynamic pricing for customers.