The impact of compatibility on innovation in markets with network effects

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.