COMPATIBILITY COMPETITION IN THE PRESENCE OF NETWORK EXTERNALITIES

A quality level is much often determined ahead of price. In imperfectly competitive markets, quality decisions are known to create the rival¡¯s price undercutting, and thus the equilibrium quality level becomes suboptimal. This paper takes a view that a quality level of a product subject to network externalities is positively related to its degree of compatibility to other brands as well as to the size of its own network. It shows that in the presence of network externalities, contrary to the literature, the suppliers tend to provide an excessive degree of compatibility because compatibility provision relaxes subsequent price competition.