Abstract

In digital markets, big technology firms like Google, Apple, Amazon, etc. have expanded across multiple products and services. Some of these online services differ from traditional services in the sense that they have a platform market structure: offered for free to users and generate advertising revenue by placing advertisements in them. In this setting, using a game-theoretic model, we study firms’ incentives to integrate an online service with the hardware product. Our analysis brings out three distinct mechanisms: strategic focus on different components’ user base, increased product differentiation, and competing away of advertising profit, to explain the profitability of adopting service integration. Interestingly, we find that as the difference in hardware product qualities/functionalities is sufficiently large, both firms’ profit are higher with service integration because of increased market power to monetize different components’ user base; otherwise, either it is not profitable for both firms or has an asymmetric effect on firms’ profit with quality advantage firm benefiting and the rival firm losing with service integration. Moreover, from a social welfare perspective, we find that there can be under-provision of service integration. Our analysis provides valuable insights to managers to understand and make platform pricing and design decisions when providing both hardware products and online services.