Optimal Compatibility in Systems Markets
We analyze private and social incentives for standardization to ensure market-wide system compatibility in a two-dimensional spatial competition model. It is shown that there is a fundamental conflict of interest between consumers and producers over the standardization decision. Consumers prefer standardization with full compatibility because it offers more variety that confers better match with their ideal specifications. However, firms are likely to choose the minimum compatibility to maximize product differentiation and soften competition. This is in sharp contrast to the previous literature that shows the alignment of private and social incentives for compatibility. We also characterize the free-entry equilibria under the maximum and the minimum compatibility. With free entry, more firms enter without standardization, but the number of available system variety is less than the one under standardization.
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