Product Compatibility in Network Industries with Switching Costs

Abstract

This paper investigates how switching costs affect product compatibility and market dynamics in network industries. A reduction in the switching cost makes the firms' products more attractive relative to the outside good, which diminishes the market expansion benefit of making products compatible. As a result, the larger firm is more likely to veto compatibility in order to maintain its installed base advantage over its rival. Therefore, public policies that reduce switching costs in network industries can change the market outcome from compatible products to incompatible products. In the former, price competition is mild and the market is often fragmented, whereas in the latter, there is fierce price competition when firms are of comparable size and in the long run the market is likely dominated by one firm.