One-Way Compatibility, Two-Way Compatibility and Entry in Network Industries

We study the strategic choice of compatibility between two initially incompatible network goods in a two-stage game played by an incumbent and an entrant firm. Compatibility may be achieved by means of a converter. We derive a number of results under different assumptions about the nature of the converter (one-way vs two-way) and the existence of property rights. In the case of a two-way converter, which can only be supplied by the incumbent, incompatibility will result in equilibrium. When both firms can build a one-way converter and there are no property rights on the necessary technical specifications, the unique equilibrium involves full compatibility. Finally, when each firm has property rights on its technical specifications, full incompatibility and preemption are again observed at the equilibrium. With incompatibility, entry deterrence occurs for sufficiently strong network effects. The welfare analysis shows that the equilibrium compatibility regime is socially inefficient for most levels of the network effects.