The Welfare Effect of Product Incompatibility in Complementary Goods Markets

This paper studies the welfare effect of product incompatibility in complementary goods markets. Complementary goods are often incompatible across brands. Incompatibility imposes a choice constraint and increases consumers' costs of switching or upgrading. Firms take advantage of incompatibility to lock in consumers. In this paper, I develop a dynamic consumer demand model and an oligopoly pricing game for complementary goods with incompatibility. The model is estimated by Simulated Maximum Likelihood and Expectation-Maximization (EM) algorithm using a large-scale individual-level consumer panel data in the U.S. men's shaving market. Estimates are used to quantify the impact of product incompatibility on price competition and consumer welfare. I solve for the counterfactual market equilibriums in which razors and blades are compatible across firms and/or technologies within firms. Results show that compatibility softens price competition. Two effects are presented when razors and blades are compatible: demand expansion effect and intensified competition effect. Razor prices are higher since firms can't lock in consumers. Blade prices are higher since demand expansion effect dominates intensified competition effect. Consumer welfare is improved overall because the benefit consumers derive from expanded choices outweighs increased product costs. However, the welfare effect varies across consumers