Welfare-improving vertical separation with network externality

- We compare the outcomes of vertical integration and vertical separation with network externalities.
- Integration has the advantage of avoiding double-margin distortion.
- Separation has the advantage of increasing network externalities.
- When both products are sufficiently close substitutes, vertical separation is more efficient than vertical integration.

Considering the interplay between network externalities and the degree of product substitutability in a vertical structure, we compare the outcomes of vertical integration and vertical separation. In contrast to previous results, we show that when both products are sufficiently close substitutes, there is a threshold level of the network externality parameter, beyond which vertical separation is more efficient than vertical integration. This is due to the internalization of the network externality by a multiproduct monopolist, which, in the balance between the extensive and intensive margin, leads to higher output prices.