Compatibility between Product Generations: The Case of Duopoly

This paper considers firm’s compatibility choice across generations of products in a duopoly setting. In particular, we analyse a situation where the combination of two compatible product systems yields higher surplus than the sum of the surplus that a consumer obtains from the two systems individually. It is shown that if maintaining compatibility is costly, depending on both firms’ first-period market shares, firms may or may not choose to make their second-generation products compatible with their respective first versions. The firms’ compatibility choices consequently will affect both firms’ pricing behaviors in the second period. Specifically we show that if the cost associated with compatibility is not too high and the difference in the firms’ first-period market shares is not too large, then both firms will choose to maintain compatibility because this allows firms to act as local monopolists over their old customers and earn higher profits. Therefore compatibility can be a tool for the firms to relax the second-period price competition. It is also shown that firms’ strategic consideration of the future profitability will affect their pricing behaviors in the first period. In particular, under certain conditions the firm with cost advantage will price “softly” in the first period to make sure its rival’s market share is not too small and thus avoids fierce price competition in the period that follows. In this case the incentive to earn monopoly profits in the future leads to a collusion-like outcome in the first period. Compatibility between Product Generations: The Case of Duopoly