Pio Baake and Anette Boom

"Vertical product differentiation, network externalities, and compatibility decisions"

JEL codes: L13; L15, D43
Keywords: vertical product differentiation; network externalities, compatibility decisions

Abstract:  We analyse the subgame perfect equilibrium of a four stage game in a model of vertical product differentiation, where the consumer´s evaluation of a product depends on its inherent quality and on its network´s size.   First, two firms choose their product's inherent quality. Then they might mutually agree on providing an adapter, before competition in prices. Finally, consumers buy. We find that, despite the high quality firm's preference for incompatibility, an adapter is always provided in equilibrium. Social welfare is greater than without an adapter and can be improved by regulating compatibility only in those cases where qualities are differentiated too much.