The Quality of Complex Systems and Industry Structure

The structure of the telecommunications industry has changed substantially in the last decade, raising public concern that the quality of our information infrastructure may be adversely affected. This paper extends the standard vertical differentiation model of imperfect competition to address the case of the choice of quality in complex systems. In these systems each demanded good consists of two complementary components whose quality may be set by competing firms. The extended framework is used to examine how changes in the vertical and horizontal structure of the industry affect the choice of compatibility, the overall system quality, the equilibrium market prices, and the allocation of surplus. The results from this analysis are interpreted in light of changes in the structure of the telecommunications industry.