Question

Explain why networks often lead to first-mover advantages, and how to use strategies such as penetration pricing to favorably change the strategic environment.

Short answer

The initial establishment causes the first-mover advantage in a network system, or the existing monopoly has more users and complimentary services than a new entrant, which is caused due to network externalities.

The new entrant can finally attract a massive pool of customers to their products using the price penetration method.

Step-by-step solution

Network Externalities

There are two types of network externalities such as:

(i) Direct network – In this case, the value of the network increases with an increase in the size of the network. These externalities are found in two-way networks such as telephone networks.

(ii) Indirect network: This is caused when the indirect value of the network increases due to the increase in the availability of complementary products and services. These are found in both one-way and two-way networks.

First-Mover Advantage

First mover advantage is caused when an existing monopoly captures a large pool of customers already enjoying their complimentary services. The entrance of a new rival would not eventually affect the existing firm.

The new entrant neither has a pool of existing users nor sufficient complementary services.

For example, think about two network providers Airtel and Jio. Airtel, already an established network provider, has a vast pool of existing customers as it is the only network available in that area. Let the consumers value its service to be $\$20$

Whereas the new network provider Jio, the new entrant to the market, provides better network facilities, and the customers value its services to be $\$30$.

However, the customers will still choose not to shift to the new network due to the network externalities, thus causing a consumer lock-in. Thus, the consumers remain stuck in the inferior services irrespective of the availability of better services in the market.

Penetration Pricing

Penetration pricing refers to the price that is charged initially by the new entrant. This price is usually low. Even the entrant might give away its products freely without any price charged to attract the a massive pool of customers.

For example, a network provider Airtel already established in the economy has a massive pool of customers with many complimentary services.

However, a new entrant named Jio cannot properly attract the customers even though their network is valued more; if it chooses the old strategy, the customers will choose to stay in their old Airtel network.

Now, Jio poses a penetration pricing method, where it gives away its network for free to the customers. Since the value of their network is more significant than Airtel's, consumers will now choose to shift to the new network as they had to bear no cost to avail of the products.

Thus, this method favors the strategic environment towards the entrant irrespective of the first-mover advantage.