Partial Compatibility and Vertical Differentiation

Abstract

In this paper we construct a game-theoretic model to analyze firms¡¦ partial compatibility choices. The quality of a hybrid system depends on the minimum of the compatibility levels chosen by firms. We find that, depending on the investment cost, the compatibility level could be incompatibility or partial compatibility. When the investment cost is very small, firms¡¦ optimal compatibility levels are partial. If the investment cost is relatively large, then firms will choose incompatibility. These results offer an explanation for why firms do not produce components which are fully compatible with their rivals¡¦.