Price Competition and Product Differentiation when Goods have Network Effects

The objective of our approach is to develop a model which captures horizontal product differentiation under environmental awareness, product innovation under network effects, and price competition whereby environmentally friendly products are costlier to produce. As an example, we refer to automobile producers, offering cars with a gasoline powered engine and one with a natural gas powered engine. The network of petrol stations provide the complementary good. The fulfilled expectation equilibrium could be either one with the firm offering the conventional engine as the only producer, one with the firm offering the new technology as the only producer, or one in which both firms share the market. Which equilibrium will emerge depends on the cost of producing energy efficient engines and on environmental awareness of the consumers. Due to the latter aspect the innovative firm has a chance to enter the market. We use a two stage game in prices and characteristics to analyse the respective market structure. We show that if environmental awareness is strong, the firm with the conventional technology will improve energy efficiency of its product. If the network effect is weak, both firms will be in the market. Prices and profits will decline if the role of the network effect becomes important. In order to find out whether private decision on the type of engine coincides with a socially optimal product differentiation, we determine the position of the two types of engine by a welfare maximizing authority.