Strategic R%D in systems industry - a network externality-based theory

The existing literature suggests that an incumbent monopolist supplier of a system component can successfully deter entry by increasing its installed base, which plays a role similar to that of the commitment value of investment in capacity. In this paper, we consider a systems market with network externality, where the consumers' utility not only depends on the network size but also on the technological quality of the product. We show that when the installed base of the incumbent fails to play its pre-emptive role to deter entry, the monopolist can deter entry by strategic R%D investment in upgrading its product. The result is independent of whether the R%D project is, ex-post, successful or not. Such entry deterrence is welfare reducing.