Strategic Choice of Network Externality and Its Impact on Digital Piracy

Network externality plays a major role in the digital products market. The strength or the degree of the network externality has serious implications on the overall value or quality of the digital product. We focus on a situation where the degree of network externality of the product is a strategic choice of a digital firm that faces a commercial pirate that produces a lower quality of that product. We characterize the strategic response of the original firm to the pirate. We find the profit-maximizing degree of network externality chosen by the original firm under any cost environment and relative quality difference between the original and pirated good. Market structure and market coverage are endogenously determined in the model, which has implications with respect to piracy. We show that the relationship between profit-maximizing degree of network externality and the relative quality difference between the products can be monotonic or non-monotonic. The pirate's response to the network effect is analyzed. Nash equilibria of the game in which both the network externality and the low quality are chosen simultaneously are also derived.