Quality Strategies in Network Markets

This paper studies network market problems in which firm(s)/platform(s) sets quality in addition to price. A well-established result in the network economics literature is that a profit-maximizing firm concerns only how quality is valued by the marginal consumer but not by inframarginal consumers, aka the Spence effect/distortion. For markets with strong network effects under which multiple market-tipping equilibria exist, I show that the validity of the previous result depends on the choice of the equilibrium selection criterion. Precisely, I show that all criteria commonly used in this literature give rise to the Spence effect, whereas the well-justified risk dominance criterion in game theory and its generalizations do not. Novel quality strategies are derived based on the latter criteria. This paper was accepted by Joshua Gans, business strategy.