Incentives to Innovate, Compatibility and Welfare in Durable Goods Markets with Network Effects

This article investigates Örmsíincentives to invest in R&D and how these choices relate to their current compatibility decisions regarding their future, durable network goods in the presence of forward-looking consumers. Product innovation is sequential with both an initially dominant Örm and a smaller competitor as potential innovators. FirmsíR&D e§orts become strategic complements for the current market leader when compatibility is present and network e§ects are strong, while they are strategic substitutes for both Örms for weak network externalities. A novelty of the article is that it gives an explanation to compatibility agreements that Örms with dominant market shares sign with smaller market players: sufÖciently innovative future products lead the dominant Örm to support future compatibility because the probability that it is the only innovator increases when compatibility is present, allowing this Örm to enjoy a higher expected future proÖt that outweighs its current lost revenue. An interesting theoretical result is that the smaller rival may reject to support compatibility in industries with a relatively smaller number of existing consumers. For less innovative future products, the dominant Örm rejects compatibility and there is a cuto§ in network externalities below which it invests more when incompatibility is present. Regarding welfare, I Önd that future incompatible networks increase expected consumer surplus and lead to more balanced market R&D incentives relative to the economy that mandates compatibility when network effects are weak.