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.