Leveraging Network Effects for Connected Products: Strategies and Implications for the Value Chain

This paper examines how a value chain can strategically harness network effects in connected products. We consider a representative two-tier value chain, in which a manufacturer sells a connected product through a retailer. Consumers derive both a standalone value and a network benefit, which increases with the size of the user base and the strength of the network effect. We investigate two strategies to effectively leverage these network effects. First, we analyze network expansion through seeding, which involves providing the product for free to a targeted group of consumers. Our analysis shows that when the production cost is sufficiently low, seeding arises in equilibrium and exhibits a “bang-bang” pattern, with either the manufacturer or the retailer exclusively undertaking seeding. Under strong network effects, the manufacturer can induce retailer seeding through a quantity-forcing contract with a wholesale discount, thereby replicating the centralized outcome in which both firms are integrated and act as a central planner. Next, we explore engineering network effects through investment. The decentralized value chain results in less efficient investment than the centralized one, leading to lower social welfare. However, when both strategies are jointly employed, we uncover a striking result: the decentralized value chain can yield higher social welfare than the centralized one. This occurs because the central planner underinvests in network effects, as investment generates a positive externality for seeded users, whereas the manufacturer may overinvest to reduce the wholesale discount, potentially resulting in greater social welfare.