Complementary Goods: Creating, Capturing, and Competing for Value

This paper studies the strategic interaction between firms producing strictly complementary products. With strict complements, a consumer derives positive utility only when both products are used together. We show that value-capture and value-creation problems arise when such products are developed and sold by separate firms (“non-integrated” producers). Although the firms tend to price higher for given quality levels, their provision of quality is so low that in equilibrium prices are set well below what an integrated monopolist would choose. When one firm can mandate a royalty fee from the complementor producer (as often occurs in arrangements between hardware and software makers), we find that the valuecapture problem is mitigated to some extent and consumer surplus rises. However, because royalty fees greatly reduce the incentives of the firm paying them to invest in quality, the arrangement exacerbates the value-creation problem and leads to even lower total quality. Surprisingly, this result can reverse with competition. Specifically, when the firm charging the royalty fee faces a vertically differentiated competitor, the value-creation problem is greatly reduced— opening the door for the possibility of a Pareto improving outcome in which all firms and consumers are better off. Notably, this outcome cannot be achieved by giving firms the option of introducing a line of product variants; competition serves as a necessary “commitment” ingredient.