Compatibility between differentiated networks

This paper develops a generalised model of network competition when consumers vary in their preferences for network size and location, and networks are vertically and horizontally differentiated. The effect of compatibility on the degree of competition between the networks is analysed. Two effects are identified as central to determining networks' incentives towards compatibility. Compatibility decreases vertical differentiation (and hence increases competition); but it also decreases the importance of market share (and so decreases competition). Which effect dominates depends on the relative importance of horizontal and vertical aspects in consumers' utilities. When network size is a relatively important factor in consumers' utilities, neither the larger nor smaller network in the unique asymmetric equilibrium wishes to be compatible. When horizontal aspects are important, both networks wish to be compatible. For intermediate cases, the larger network does not wish to be compatible, in contrast to the smaller network. The model may explain the dynamics of network industries, particularly interconnection agreements between Internet service providers.