Compatibility or Fit? Pricing and Adoption of Incompatible Technologies Under Network Effects∗

When choosing between incompatible technologies that are characterized by network effects in business or consumer markets, e.g., software (Microsoft vs. Open Source) or “Walkie-Talkie” phones (Direct Connect vs. Push to Talk), customers must decide between compatibility with others and individual fit. Given differing customer preferences, we study the adoption dynamics and pricing strategies of firms selling to a multi-segment market and offering incompatible technologies that are characterized by network effects. When firms enter the market simultaneously, there is less compatibility compared to the social optimum. If one firm enters the market first, it can use a “divide and conquer” strategy to increase its profit compared to the simultaneous entry scenario, even when there are no switching costs. With non-negative switching costs, the first mover can increase its profit or market share, resulting in more compatibility than the social optimum. We study how the threshold switching cost depends on the strength of the network effects. In our model, the early adopters, who are “locked-in” because of switching costs, never regret their decision to adopt, whereas the late adopters, who are not subject to switching costs, are exploited by the incumbent firm. We apply our framework to examine adoption dynamics and pricing strategies when a firm competes with an unsponsored (free) technology. The presence of the free technology increases consumer surplus. If the free technology is available in the market first, increasing switching costs further increases consumer surplus. ∗We thank Eric Van den Steen, Thomas Weber, Stefanos Zenios, participants of the Workshop on Information Systems and Economics (Seattle 2003), seminar participants at Stanford University, and especially Tunay Tunca for helpful comments. †Graduate School of Business, Stanford University, [email protected]. ‡Graduate School of Business, Stanford University, [email protected].