Symposium on Compatibility: Incentives and Market Structure

VARIETY may be the spice of life, but the price of variety is high in markets where products and services need to be compatible to function properly. Standardization permits consumers to assemble desired systems from component parts, to drive automobiles with a modicum of safety, to transport data from one computer to another, to plug electrical appliances into different sockets, etc. The need for standardization is a constraint on product variety. In most situations, the tradeoff between variety and standardization is established by an unregulated market. The five papers that appear in this symposium address how successfully markets make this tradeoff. Matutes and Regibeau [1988] and Economides [1989] showed that in some circumstances the producers of alternative technologies have strong incentives to design their products to be compatible. When products function together as necessary parts in a system (i.e. they are complements), compatibility reduces the incentive of competing firms to set low prices for component parts because low prices increase the sales of a compatible rival. Despite higher prices, consumers can be better off because compatibility allows them to assemble systems that are closer to their ideal configurations. Compatible designs may emerge as the preferred choice by producers in markets with network externalities. Network externalities are a source of scale economies that arise from the demand side of the market (Rohlfs [1974]). A compatible technological design increases the value that consumers derive from a firm's product. Compatibility gives the consumer the benefits of other firms' networks. In markets with network externalities, firms that are similar in size and in other competitive characteristics may prefer compatibility because the added benefits encourage each firm to set a higher price. This parallels the incentives for compatibility in markets where (similar) firms produce complementary products. Unfortunately, coincidence between the compatibility choice that is best for producers and the choice that is best for total economic performance is not likely to hold in many real situations. In the papers by Matutes and Regibeau [1988] and Economides [1989], similarity of competing firms reinforces a desire for compatibility. Katz and Shapiro [1985] showed that in a market with network externalities, the sponsors of technologies that differ in the size of the installed base may have different preferences for compatibility. For example, a dominant firm might prefer a technological design that is