The impact of compatibility on innovation in markets with network effects

Abstract

This article analyses the relationship between compatibility and innovation in markets with network effects using a model of competition with endogenous R&D, commercialization and compatibility. Incumbent acquisition of an innovation or profit from entry provides entrepreneurs with an incentive for developing technological improvements. Entrepreneurs receive greater returns for the innovation if larger incumbents offer compatibility with their installed base. As a result, entrepreneurs must innovate strategically to pre-empt an incompatibility response from incumbents. Similarly, small incumbents also bid strategically to block entry or rival acquisition if it also avoids an incompatibility response from a larger incumbent. A credible threat of incompatibility reduces the entrepreneur's reserve to sell an innovation, but can also increase offers to acquire the innovation from smaller incumbents attempting to avoid incompatibility. This leads to a complex relationship between the strength of network effects, innovation incentives, the entrepreneur's ambition for improvement and potentially disrupting the compatibility regime. For weak to moderate network effects entrepreneurs are likely to target more substantial, but improbable innovations such that their network is sufficiently attractive for incumbents to offer compatibility. For a small range of sufficiently strong network effects, entrepreneurs target incremental innovations to avoid the incumbent threatening incompatibility. JEL classifications: L15, L26, L50, O31Abstract This article analyses the relationship between compatibility and innovation in markets with network effects using a model of competition with endogenous R&D, commercialization and compatibility. Incumbent acquisition of an innovation or profit from entry provides entrepreneurs with an incentive for developing technological improvements. Entrepreneurs receive greater returns for the innovation if larger incumbents offer compatibility with their installed base. As a result, entrepreneurs must innovate strategically to pre-empt an incompatibility response from incumbents. Similarly, small incumbents also bid strategically to block entry or rival acquisition if it also avoids an incompatibility response from a larger incumbent. A credible threat of incompatibility reduces the entrepreneur's reserve to sell an innovation, but can also increase offers to acquire the innovation from smaller incumbents attempting to avoid incompatibility. This leads to a complex relationship between the strength of network effects, innovation incentives, the entrepreneur's ambition for improvement and potentially disrupting the compatibility regime. For weak to moderate network effects entrepreneurs are likely to target more substantial, but improbable innovations such that their network is sufficiently attractive for incumbents to offer compatibility. For a small range of sufficiently strong network effects, entrepreneurs target incremental innovations to avoid the incumbent threatening incompatibility.JEL classif...

R&D rivalry with endogenous compatibility

“…(2014) argue that the installed base of incumbents need not deter quality improving innovation if the innovator sells technology to the incumbents rather than tries to enter as a seller. Bond‐Smith (2019) extends this argument in a model in which compatibility is endogenous. Maruyama and Zennyo (2017) imagine an exogenous increase in the efficiency of R&D in a platform rivalry with royalties for content sharing.…”

R&D Investments in Markets with Network Effects

“…The following research is meant to contribute to the three strands of innovation literature: (1) works on firms' R&D investments (Atallah 2007;Marini et al 2014;Geldes et al 2017), 2works on markets with network effects (Choi et al 2010;Dan 2018;Bond-Smith 2019), and (3) innovation policy literature (Eklinder-Frick and Age 2017; Cabon-Dhersin and Gibert 2019).…”