Vertical product differentiation, network externalities, and compatibilitydecisions

We analyse the subgame perfect equilibrium of a four-stage game in a model of vertical product differentiation, where the consumer's evaluation of a p roduct depends on its inherent quality and on its network's size. First, tw o firms choose their product's inherent quality. Then they may mutually agr ee on providing an adapter before competing in prices. Finally, consumers b uy. We find that, despite the high quality firm's preference for incompatib ility, an adapter is always provided in equilibrium. Social welfare is grea ter than without an adapter and can be improved by regulating compatibility only in those cases where qualities are differentiated too much. (C) 2001 Elsevier Science B.V. All rights reserved.