Welfare Effect of Network Compatibility Promotion under Strategic R&D Competition: The Role of Consumer Expectations in a Hotelling Model

We conduct welfare analysis of an improvement in compatibility in a network goods market, where firms compete on price and research and development (R&D) activity. Using a Hotelling model, we explore the impact of compatibility on a firm's R&D activity and on producer surplus, consumer surplus, and social welfare. Focusing on the difference in the formation of consumer expectations for network sizes, i.e., rational and active expectations, we demonstrate the following. First, under rational (active) expectations, an improvement in compatibility reduces (does not affect) a firm's R&D activity, but increases (decreases) consumer surplus. However, except for perfect compatibility, although the level of R&D activity is greater under rational expectations than under active expectations, consumer surplus is smaller under rational expectations than under active expectations. Second, regardless of the difference in the formation of consumer expectations, an improvement in compatibility increases producer surplus and social welfare. In addition, producer surplus and social welfare are greater under rational expectations than under active expectations. Finally, we consider the implications of social optimality for perfect compatibility.