The compatibility decision game: network externalities and the (variable) costs of compatibility

Using a non-cooperative two-stage game, this paper studies the effects of the variable costs of achieving compatibility on the strategic choice of producing compatible/incompatible goods in Cournot and Bertrand duopolistic network industries. A broad variety of sub-game perfect Nash equilibria can emerge depending on the interaction between the coordination cost parameters of the linear and quadratic technologies of compatibility, ranging from a deadlock, with product compatibility or incompatibility, to an anti-coordination scenario, in which only one firm strategically adopts product compatibility. A prisoner’s dilemma, in which self-interest and mutual benefit of product (in)compatibility conflict, can also occur. The welfare analysis reveals that parametric regions exist where consumers and firms are better off, showing the possibility of Pareto-superior situations. The article also considers the mode of competition game showing that quantity competition is the unique scenario emerging endogenously, but the sub-game perfect Nash equilibrium can be Pareto inefficient (prisoner’s dilemma) or Pareto efficient (deadlock) depending on the relative size of the network effect.