Abstract: Competing firms often form links with their rivals,which can affect the way they compete in the product market.In this paper,we develop a model of a two-stage game to examine the incentives of the competing firms to form links and the resulting network structures of the link formation.In the first stage of the game,the firms with vertical product differentiation decide whether to form links with their rivals. After observing the network structure in the second stage,the firms compete in prices.Our analysis shows that,the equilibrium network structure is determined by the link effect,link costs,and consumers preferences.The equilibrium network structure is either a star network,in which one firm is directly linked to all other firms that are not linked to each other,or an empty network in which no link is formed.We also show thatas com pared with the socially optimal network,there are less links in the equilibrium network due to a lack of individual incentives in link formation.Public policy should be designed to encourage firms to form links.

Key words: link effect, vertical differentiation, equilibrium network, social efficient network