Compatibility, Networks, and Competition: A Review of Recent Advances

This paper is a selective survey of the economic literature on the functioning of the markets where goods are subject to network externalities. Telecommunications, transports and computers give examples of markets where, for various reasons, these network effects appear. We first examine how the consumer's choices are affected by these network effects, as they are when switching costs are at work. On the markets of network goods, consumer's decisions depend either on the choices of previous generations, or on consumer's expectations, or both. The results are that choices may exhibit inefficiencies: a “wrong” good may be adopted because of the lack of coordination between individual decisions. We then turn to the study of a firm's strategies: when firms produce network goods, they may choose to make their product compatible or incompatible with the rival's good. Moreover, the nature of price competition is affected by the compatibility regime that prevails. This explains why consumers, who would always choose compatibility if prices were constant, might in fact prefer incompatibility if this regime intensifies price competition. In conclusion, compatibility choices by the firms and welfare implications are briefly examined.