The impact of compatibility on innovation in markets with network effects

ABSTRACT

This article analyses the relationship between compatibility and innovation in markets with network effects using a model of competition with endogenous R&D, commercialization and compatibility. Compatibility is a mutual decision between firms and demand is partially dependent on overall consumption across compatible networks. Incumbent acquisition of an innovation or profit from entry provides entrepreneurs with an incentive for developing technological improvements and entrepreneurs receive greater returns if larger incumbents offer compatibility with their installed base. But for sufficiently weak network effects a large incumbent increases demand for its own product by denying compatibility to rivals. As a result, a credible threat of incompatibility reduces the entrepreneur's reserve to sell an innovation, but can also increase offers from smaller incumbents to acquire the innovation if it also avoids an incompatibility response from a larger incumbent. In response, entrepreneurs adjust their research effort in order to target a favourable compatibility regime that maximizes profit from entry or offers to acquire the innovation from incumbents. This leads to a complex relationship between the strength of network effects, innovation incentives, the entrepreneur's ambition for improvement and potentially disrupting the compatibility regime.

KEYWORDS:

• Network effects
• innovation
• compatibility

JEL CLASSIFICATIONS:

• L15
• L26
• L50
• O31

Acknowledgments

I am thankful for helpful comments and suggestions from the editor, Joanna Poyego-Theotoky and several anonymous referees as well as participants at the Australasian Economic Theory Workshop and department seminar at La Trobe University.

Disclosure statement

No potential conflict of interest was reported by the authors.

ORCID

Steven Bond-Smith http://orcid.org/0000-0003-2500-1782

Notes

1 Source: The Economist (2016) http://econ.st/24Edsbi. Accessed November 2016.

2 Source: Reuters (2016) http://reut.rs/1QdB2Em. Accessed November 2016.

3 Source: Reuters (2015) http://reut.rs/1I4xiDp. Accessed November 2016.

4 The term ‘early stage investments’ refers to Seed/Angel and Series A investments. Source: CBInsights (2016) https://www.cbinsights.com/blog/iot-funding-startups-q1-2016/.

5 Full derivation of equilibria with zero output by one or more firms is shown in Appendix B for a market with two incumbents and one entrant, available at https://bcec.edu.au/assets/2018/12/Impact_Appendix_B.pdf

6 In these derivations, n is defined by the final number of firms competing, such that if a new firm enters in Stage 2, n is one higher than if the innovation is acquired in Stage 2. An alternative derivation is shown in Appendix C where equilibrium is defined separately for Firm 1, rivals and the entrant with a constant definition for n, irrespective of entry or acquisition, available at https://bcec.edu.au/assets/2018/12/Impact_Appendix_C.pdf

7 For the purpose of this analysis, output is calculated as a function of output by firms on compatible networks ($\sum _{j=2}^n{q}_j$) to simplify finding equilibrium under autarky. Conversely, Norbäck, Persson, and Tåg (2014) assume all installed bases are incompatible so choose to find equilibrium using aggregate output of incompatible firms. Either approach finds the correct equilibrium. For other regimes not analysed here, (e.g. Firm 2 autarky) a mixed approach could be used such as aggregate output by autarkic firms and aggregate output by compatible firms, or whatever approach is appropriate given the compatibility regime.

8 See Appendix C for equilibrium defined by rival aggregate demand with a constant definition for n, irrespective of entry or acquisition, available at https://bcec.edu.au/assets/2018/12/Impact_Appendix_C.pdf

9 Additional charts are shown in appendix A describing the profit under compatibility and autarky, the auction outcome, threats of autarky and equilibrium compatibility regime, available at https://bcec.edu.au/assets/2018/12/Impact_Appendix_A.pdf

10 Additional charts are shown in appendix A describing the profit under compatibility and autarky, the auction outcome, threats of autarky and equilibrium compatibility regime, available at https://bcec.edu.au/assets/2018/12/Impact_Appendix_A.pdf

11 Note that the calibration here has changed. With more incumbent firms, the impact of compatibility is most apparent with a smaller entrant.

12 With three firms $\alpha <0.72$. This limit is not required for two firms or once the endogenous compatibility regime is included because strong network effects support compatibility.