The welfare effect of quality degradation in the presence of network externalities

This paper examines how the presence of network externalities affects a monopolist's incentive for quality degradation and its welfare consequence and endogenise the firm’s forward and backward compatibility decisions between the original good and the degraded good.

Abstract

This paper examines how the presence of network externalities affects a monopolist's incentive for quality degradation and its welfare consequence. The software and Internet service industries provide our primary motivation. The network externality may lead to a Pareto-improving quality degradation that would not be realised in the absence of network externalities. However, it may also overturn a potentially Pareto-improving quality degradation to a welfare-reducing one, or result in the realisation of a welfare-reducing quality degradation that would be avoided without network externalities. We also endogenise the firm's forward and backward compatibility decisions between the original and degraded goods.