System products are those which generate value when combined
with their complements. System products, such as
computer hardware and software, vedio- casette
recorder and vedio tape, automated teller machines and ATM
cards, etc, play an important role in modern life.
The most distinctive character- istic of system
products is the network externality. Positive network exter-
nalities arise when a good is more valuable to a user the more
users adopt the same good or compatible one.
In this study, I intend to investigate two important issues
facing the producers of system products: the first
is the technological standards ado- pted by the firm,
and the second is the compatibility decisions between
the competing firms. I construct a two-period duopoly game to
analyze these problems.
In the first model, the firms can adopt either the incremental
innovation which is backward compatible with the old
standard or technology revolution which is backward
incompatible with the old standard. In markets with heter-
ogeneous consumers, network externalities, and fulfilled
expectations, it is shown that the factors which
influence firms'' adoption of technology standards
include: the innovation benefit, the existing installed base of
the old stan- dard, the relative technological
advantage of the dominant firm, and so on.
Other things being equal, this study shows that technological
changes does not necessarily favor advanced technology
standard. With symmetric duopoly, revolutionary
technology will be adopted only if it generates a benefit
greater than the sum of the network benefit and the
compatibility benefit created by incremental
innovation. It is shown that the network benefit and
the compatibility benefit are both increasing with network
externalities.
With asymmetric duopoly, where one firm enjoys technology
advantage over the other when they both adopt the
incremental innovation. We show that a dominant firm
always wants to adopt a strategy different from its inferior
rival, but the inferior rival always wants to mimic
the dominant firm''s.
This gives two managerial implications. First, the dominant firm
can opt for an upgraded technology to made the inferior
firm trapped in the old standard. Second, when the
network externality is strong and the technology advantage of
the dominant firm is large, both firms are better off if the
dominant takes the leader''s role.
This study also finds that the inferior firm''s adoption of an
upgraded tech- nology may harm the dominant firm by
reducing the latter''s profit. This implies that it can be
reasonable for the dominant firm to encourage cloning.
The second model investigates whether the firm should made its
product com- patible with its rival''s. The literature
has emphasized the network effect of compatibility,
with little attention being given to the fact that product
differentiation can also decrease with compatibility. In this
study, we setup a two-stage duopoly game to deal with
the latter possibility and how the firms choose the
optimal degree of compatibility. This paper shows that the
compati- bility choices of the firm depend on the gains
from the network effect, the compatibility effect,
and the loss from increasing competition. This study also
shows that the factors that affect the optimal compatibility
choices of the firm include: the existing installed
base of the firm, the cost advantage / disadvantage
of the firms, and the degree to which compatibility impacts on
product differentiation. These results are robust, no matter
firms compete in quantity or in prices. Moreover, this
study suggests that competition plus co- operation
features the relation among firms in system industries.