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This paper compares vertical integration and vertical separation with network externalities. Contrary to conventional wisdom, if network effects are stronger than the threshold level of the network externality parameter, manufacturers’ strategic choices of wholesale prices move in opposite directions (i.e., wholesale prices may be strategic substitutes under Bertrand competition). Second, if the strength of network effects is strong enough, both profits and outputs are larger under vertical separation than under integration. Finally, if network effects are strong (weak), outputs (wholesale prices, retail prices), consumer surplus, and social welfare are higher (lower) under separation than integration.

Fershtman and Judd (1987) show that profit-oriented owners delegate pricing decisions to managers through contracts that incentivize them to behave less aggressively. Hoernig (2012) extends their analysis to environments with network effects and finds that, when network effects are strong enough, the result is reversed and that optimal delegation contracts incentivize managers to behave more aggressively. This paper revisits Hoernig (2012) by assuming that consumers form expectations about network sizes before owners choose delegation contracts, in contrast with Hoernig’s (2012) assumption that expectations are formed after the contracts are chosen. That is, the current study employs fulfilled (or passive) expectations, while Hoernig (2012) uses rational (or responsive) expectations. We show that under the fulfilled expectations, Fershtman and Judd’s (1987) results hold, regardless of the strength of the network effect.

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.