Peer Effects and Consumption Behavior in Interconnected Networks

I consider peer effects of network externalities in a competitive telecommunica-tion market. The magnitude of network externalities depends on whether the caller and the receiver are in the same peer group. Technically, interconnection between carriers can eliminate network externalities, but carriers may adopt termination-based price discrimination to reduce compatibility. When termination-based pricing is prohibited, carriers cannot exploit network externalities. Peer effects are equiva-lent to consumers with vertically heterogeneous tastes. There is a unique subscrip-tion equilibrium. On the other hand, when carriers offer termination-specific prices, peer effects have a substantial impact on the equilibrium. Because of the network externalities created by incompatibility, there might be multiple stable equilibria. Carriers may specialize to serve different consumer groups in a stable equilibrium even if they are identical ex ante. If carriers anticipate such an equilibrium, they would like to negotiate a high interconnection fee and offer intra-network discounts.