Abstract

Positive network effects arise where incremental product use increases the utility of users of compatible products (user-positive effects), but also in situations where product use imposes negative externalities that selectively affect the adopters of incompatible alternatives (nonuser-negative effects). This paper compares the social optimality of firms’ incentives for compatibility under these two regimes. Using a “location” model of differentiated products, I find that, under both regimes, incentives for unilateral action to increase compatibility tend to be suboptimal when firms’ networks are close in size, but they may be excessive for small firms when networks differ greatly in size. The result is consistent with prior analysis of the user-positive context (e.g., Katz & Shapiro, 1985), but challenges the intuition that activities involving negative externalities are always oversupplied in an unregulated market. Public policy implications are discussed.

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