Optimal research effort and product differentiation in network industries

This paper studies the introduction of a new and incompatible technology in a spatial market with network externalities. In competition with an established network the paper investigates how long an entrant optimally should do research before entering the market and what level of product differentiation should be chosen in order to maximize its present value profits. Research time is important as it not only determines the quality of the technology that is introduced; it also has consequences for how successfully the two competing firms build their network of users. First, the paper derives a function characterizing the intertemporal evolution in market shares resulting from the newcomer’s choices. Second, it is shown that each level of technological quality is associated with both a minimum and a maximum level of product differentiation that should be chosen in equilibrium. Third, the entrant’s problem is solved by numerical methods.