Compatibility and Proprietary Standards

From Information Systems at Pitt Business

In many information technology (IT) markets, network effects arise in compatible products where one user’s consumption utility increases with the number of users adopting the same product.When network effects are present, consumers benefit from compatibility since a large and standardized product network confers greater utility that would not be available in the absence of compatibility. From a societal standpoint, standardization across different product formats yields much larger social surplus than the sum of those obtained from several smaller product networks. However, standardization can be difficult to achieve. The dominant firms may prefer not to be compatible with other products so that they can enjoy a number of strategic advantages such as a higher price premium, a faster rate of market penetration and the possibility to control the design interface. Consumers may prefer product variety when they have heterogeneous preferences. New entrant firms may be reluctant to adopt a dominant standard if standardization results in sacrificing their unique product features or giving up much of their prior investments in product development. In any case, significant private and social loss may occur and technology innovation can be retarded.

Amid concerns over tradeoffs between the benefits and associated costs from standardization, an alternative way to achieve compatibility may emerge from the market for digital goods (e.g., software, digital media). As the content carried by these products is in a digital format, communication between incompatible products can frequently be realized through a converter. For example, Microsoft Word users can open Word Perfect documents by using a file converter. Software can be used to convert music and video files between different formats to play on different devices. In short, the digital nature of these products (or their outputs) opens up the possibility of achieving compatibility without incurring significant costs or seriously degrading performance. When standardization is attained through converters, technology innovation and adoption can be greatly facilitated since firms can maintain their unique product features and spare the need to redesign their products, leading to greater product variety and minimal risk of stranding consumers on a non-dominant technology.

[edit] Abstract

In markets that exhibit network effects, the presence of conversion technologies provides an alternative mechanism to achieve compatibility. This study examines the impact of conversion technologies on market equilibrium in the context of sequential duopoly competition and proprietary technology standards.

We analyze this question by departing from the extant literature to endogenize the decision to provide a converter and incorporate explicit negotiations between firms concerning the extent of conversion. We argue that these choices better reflect the environment facing firms in IT-industries and find that these decisions change some of the established results in the literature.

Specifically, we find that unless network effects are very large, the subgame perfect equilibrium involves firms’ agreeing on providing converters at a sufficiently low price to all consumers. At this equilibrium, both the entrant and the incumbent are better off since the provision of converters alleviates price competition in the market and leads to both higher product revenues and higher proceeds from the sale of converters. Moreover, under some circumstances the provision of converters is welfare enhancing. These findings have important implications for research and practice in the adoption of new digital goods as the introduction of conversion technologies can reduce the social costs of standardization without compromising the benefits of network effects.

[edit] Paper Information

Authors:  Charles Liu, Esther Gal-Or, Chris Kemerer, Michael Smith

[edit] Keywords

Network Effects, Network Externalities, Conversion Technologies, Compatibility, Proprietary Technology Standards, Digital Goods.