Switching Costs and Network Compatibility

This paper investigates how consumer switching costs affect firms’ compatibility choices and social welfare in network industries. Firms face a choice between two modes of competition: make their networks incompatible and compete fiercely for market dominance, or make their networks compatible and have mild competition. By incentivizing firms to harvest their locked-in consumers rather than price aggressively for market dominance, switching costs tip the balance in favor of compatible networks and mild competition. A public policy that reduces switching costs also tends to make networks incompatible, and results in small efficiency gains at best. Combining the policy with a mandatory compatibility policy, however, can lead to sizable efficiency gains.