Compatibility, intellectual property, innovation and efficiency in durable goods markets with network effects

Abstract

This paper analyses firms' behaviour towards compatibility and the relation of these decisions with their incentives to invest into improving their durable, network goods. By using a sequential game where the dominant firm plays first, we give its competitor the ability to build on innovations previously introduced by the market leader. Recognizing the intertemporal linkage in forward looking customers' purchasing choices, we find that in anticipation of a relatively large quality improvement by the rival, strategic pricing leads the dominant firm to support compatibility even if it could exclude its rivals by using a patent for its invention. Furthermore, not only doesn't interoperability de-facto maximise social welfare but we also identify no market failure when network effects are not particularly strong