Analyzing Pricing Strategies for Online-Services with Network Effect

Abstract

In this study, we model firms that sell a product and a complementary online service, where only the latter displays positive network effects. That is, the value each consumer derives from the service increases with the total number of consumers that subscribe to the service. In addition, the service is valuable only to consumers who buy the product. We consider two pricing strategies: 1) bundle pricing, in which the firm charges a single price for the product and the service; and 2) separate pricing, in which the firm sets the prices of the product and the service separately, and consumers self-select whether to buy both or only the product. We show that, in contrast to the common result in the bundling literature, often the monopolist chooses not to offer the bundle (he either sells the service separately or not at all) while bundling would increase consumer surplus and social welfare. Thus, under-provision of the service can be the market outcome. We also demonstrate that network effects may cause the under-provision of the service.