Price and quantity competition with network externalities: Endogenous choice of strategic variables

Abstract We consider the endogenous choice of strategic variable (price or quantity) in a duopoly market for differentiated goods in the presence of network externalities. We show that if the rival goods are substitutes in demand, but the degree of network compatibility is large enough to outweigh the substitution effects, each firm chooses price as its strategic variable. This finding is a rare exception to the usual result that if the goods are substitutes, each firm would choose quantity as its strategic variable. Moreover, we show that two non‐standard results hold when the above condition is satisfied and the efficiency difference between the two firms is large. First, the price of the less efficient firm is higher under price competition than under quantity competition. Second, in a situation where one firm sets quantity and the other firm sets price, the profit of the more efficient firm is higher when it is the quantity‐setter than when it is the price‐setter, and the opposite is true for the less efficient firm.