Network externalities and vertical integration: The case of the World Wide Web software market

Network externalities exist when the value of a product or service is positively related to the size of its installed base (or network). This phenomenon occurs because individuals derive benefits from the network of users above and beyond those benefits derived from the intrinsic features of a product or service. A large body of theoretical research suggests that the market behavior of products and services subject to network externalities differs significantly from traditional goods and that network externalities have important implications for product pricing, adoption, diffusion, and competition. Despite these claims, there is little empirical evidence supporting the existence of network externalities and the extent and impact of the phenomenon remains largely unknown. Further, many goods and services which have been suggested as being subject to network externalities are made up of composite goods, that is more than one class of product is necessary for a user to derive utility (i.e. client and server). However no study to date has empirically investigated network externalities in composite goods markets, nor has a study investigated the price benefits offered to a firm which vertically integrates and provides the market with both components of a composite good. In an effort to further knowledge in this field, this study extended accepting modeling and methodological techniques to empirically test for the existence, sources, and impact of network externalities in a composite goods market--the market for world wide web software. When a data sample of commercial Web servers from August 1995 to February 1997 was examined, the following results emerged: (1) The network externalities hypothesis was consistently supported across a selection of specifications and sub-samples. (2) The direct benefits of vertical integration (offering a browser) were more significant than the indirect benefit of growing server market share. (3) Additional network benefits were derived from database and security standards. (4) Firms which offered a trial version of their product were able to command a significant price premium over their rivals. And (5) the network externalities hypothesis was not supported in a market dominated by free products