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This paper explores the capacity choice for a public firm that is a social welfare-maximizer and a private firm that is an absolute profit-maximizer in the context of a quantity-setting mixed duopoly with a simple mechanism of network effects where the surplus that a firm’s client gets increases with the number of other clients of the firm. In this paper, we show that the social welfare-maximizing public firm chooses under-capacity irrespective of both the degree of product differentiation and strength of network effects, whereas the absolute profit-maximizing private firm chooses over-capacity irrespective of both the degree of product differentiation and strength of network effects, which is strikingly different from the results on the capacity choice problems for public and private firms obtained in price-setting mixed duopolistic markets in the existing literature.

This paper investigates the capacity choice issue for a public firm that is a social welfare-maximizer and a private firm that is an absolute profit-maximizer in the context of a quantity-setting mixed duopoly with network effects where the surplus that a firm’s client gets increases with the number of other clients of the firm.^{1} Similar to the works on the capacity selection issues in private oligopolies composed of private firms only, such as the seminal works of Dixit [^{2}. Most recently, Nakamura [^{3} In this paper, in a quantity-setting mixed duopoly with network effects, we confirm the robustness of the results of the difference between the quantity and capacity levels of both public and private firms in the case of price-setting mixed duopolies obtained by Nakamura [^{4}.

In this paper, we show that in quantity competition with the network effects à la Katz and Shapiro [

The remainder of this paper is organized as follows. In Section 2, we formulate a quantity-setting mixed duopolistic model with capacity choice of both the social welfare-maximizing public firm and the absolute profitmaximizing private firm with network effects à la Katz and Shapiro [

We formulate a quantity-setting competition model in a mixed duopoly with the capacity choice of both a public firm and a private firm and with an additional term that reflects network effects in the fashion of Katz and Shapiro [^{ 5}.

We assume that firm 0 is a public firm that is a welfare-maximizer whereas firm 1 is a private firm that is an absolute profit-maximizer. Similar to Hoernig [

where and are demand parameters. indicates the strength of network effects, and is the consumers’ expectation on firm i’s equilibrium market share. This specification implies the following inverse demand functions for positive demand:

.

As explained in Hoernig [

where denotes the income of the representative consumer and represents some symmetric expectation function. In this paper, as in Hoernig [^{6}

We further suppose that both firms adopt identical technologies represented by cost function, where is the capacity level of firm . Following Vives [^{7} This cost function implies that if each firm’s output level equals its capacity level, , then the long-run average cost is minimized. The profit of firm is given by,. Consumer surplus as the representative consumer utility is represented as follows: , whereas producer surplus is given by the sum of the profits of both firms 0 and 1,. Finally, we suppose that social welfare in this paper is equal to the sum of consumer surplus and producer surplus.

We investigate the game with the following two stages: In the first stage, firms 0 and simultaneously set their capacity levels. In the second stage, after both the firms observe each other’s capacity level, they engage in a quantitysetting competition. In the fashion of Hoernig [

We solve the game by backward induction from the second stage to obtain the rational expectations subgame perfect Nash equilibrium. In the second stage, firm 0 maximizes social welfare with respect to, whereas firm 1 maximizes its absolute profit with respect to. The best-response functions of both firms 0 and in the second stage are given as follows:

From Equations (1) and (2), we find that for any strength of network effects and degree of product differentiation, , is decreasing in, and thus the quantity levels of both firms 0 and 1 are strategic substitutes .

Furthermore, we obtain the rational expectations Nash equilibrium of the quantity-setting stage by substituting the two conditions and into the best-response functions of both firms 0 and 1. Then, we obtain

In the first stage, both firms 0 and 1 know that their capacity choice affects their quantity levels in the second stage. Given Equations (3) and (4), firms 0 and 1 simultaneously and independently set their capacity levels with respect to social welfare and own absolute profit, respectively. Thus, by solving the first-order conditions of firms 0 and 1 in the first stage, we have

yielding

,

.

Note that superscript represents the subgame perfect equilibrium market outcomes with consumers’ rational expectations in quantity competition. Thus, the output levels of both firms 0 and 1 in the equilibrium are given as follows:

,

.

From easy calculations, we obtain the following results on the difference between the output and capacity levels of both firms 0 and 1:

,

.

Thus, we recognize that the social welfare-maximizing public firm 0 chooses under-capacity irrespective of the strength of network effects, , and demand parameter, , whereas an absolute profit-maximizing private firm 1 always chooses over-capacity. By summing the above two facts, we obtain the following proposition on the differences between the quantity and capacity levels of both firms 0 and 1.

Proposition 1 Social welfare-maximizing public firm 0 chooses under-capacity, , for any value of the demand parameter and any strength of network effects. In contrast, absolute profit-maximizing private firm 0 chooses over-capacity, , for any value of the demand parameter and any strength of network effects.

Before we state the intuition behind Proposition 1, we need to confirm the strategic relation between the capacity levels of firms 0 and 1. From easy calculations, we obtain the following results:

,

.

Thus, we find that the capacity levels of firms 0 and 1 are strategic substitutes. First, we state the intuition on why the difference between the quantity and capacity levels of public firm 0 is always positive irrespective of both the strength of network effects and degree of product differentiation. Firm 0 attempts to increase the quantity level of firm 1 in order to raise the equilibrium social welfare. Thus, the less aggressive behavior on the capacity setting of firm 0 is explained by the following two effects: 1) the negative association between the quantity level of firm 1 and the capacity level of firm 0, which is described in Equation (4), and 2) the strategic substitutability between the capacity levels of firms 0 and 1 and the positive association between the quantity and capacity levels of firm 1. More precisely, from 1), firm 0 can directly increase the quantity level of firm 1 by refraining from increasing its capacity level, and from 2), firm 0 can increase the quantity of firm 1 through raising the capacity level of firm 1 by refraining from increasing its capacity level. Consequently, firm 0 always chooses under-capacity irrespective of the degree of product differentiation and strength of network effects, which is strikingly different from the result that a social welfare-maximizing public firm chooses over-capacity in a price-setting mixed duopoly with network effects as considered in Nakamura [

In sum, as compared with the results on the difference between the quantity and capacity levels of both the public firm and private firm in price competition with network effects, we find that the differences between their quantity and capacity levels obtained in quantity competition are more simple. In addition, in the case of quantity competition with substitutable goods and network effects, as considered in this paper, the differences between the quantity and capacity levels of a social welfare-maximizing public firm and an absolute profit-maximizing private firm are the same as those obtained in the case of a quantity-setting mixed duopoly without any network effects as explored in Ogawa [

This paper explored the capacity choice for a public firm that is a social welfare-maximizer and a private firm that is an absolute profit-maximizer in the context of a quantity-setting mixed duopoly with network effects à la Katz and Shapiro [

In contrast, in quantity competition with network effects, which we considered in this paper, the social welfare-maximizing public firm chooses under-capacity irrespective of the degree of product differentiation and strength of network effects, whereas the absolute profitmaximizing private firm chooses over-capacity irrespective of the degree of product differentiation and strength of network effects. The intuition behind these results are as follows: On the difference between the quantity and capacity levels of the social welfare-maximizing public firm, the firm attempts to increase the quantity level of the rival private firm in order to enhance social welfare. More concretely, regardless of the degree of product differentiation and strength of network effects, the social welfare-maximizing public firm tries to increase the quantity level of the private firm by refraining from increasing its own capacity level, directly through the negative association between the quantity level of the private firm and its own capacity and indirectly through the strategic substitutability between the capacity levels of the firms and the positive association between the quantity and capacity levels of the private firm. In addition, the private firm tends to increase its capacity level through the positive association between its quantity and capacity levels, and through the combination of the strategic substitutability between the capacity levels of both the firms and the positive association between its own quantity and capacity levels in order to be competitive with the social welfare-maximizing public firm, implying that the private firm chooses over-capacity regardless of the degree of product differentiation and strength of network effects.

Finally, we mention an open problem that we need to tackle in the future. Throughout this paper, we considered the absolute profit as the objective of a private firm. In some sort of new papers, we should explore the results on the capacity choice issues between social welfaremaximizing public firms and absolute profit-maximizing private firms on the basis of the strength of network effects and degree of product differentiation under the assumption that the objective function of the private firms is its relative profit.

Nakamura thanks the financial support by KAKENHI (25870113). All remaining errors are our own.