Product improvement and technological tying in a winner-take-all market

In a winner-take-all duopoly market for systems in which firms invest to improvetheir products, a monopoly supplier of an essential system component may havean incentive to advantage itself by technological tying; that is, by designing thecomponent to work better in its own system. If the vertically integrated firm isprevented from technologically tying, then there is a pure strategy equilibriumin which the more efficient firm invests and serves the entire market. Howeverother equilibria may exist, including a pure strategy equilibrium in which theless efficient firm invests and captures the market and mixed strategy equilibriain which each firm captures the market with positive probability. In contrast, ifthe vertically integrated firm is able to degrade the quality of its rival's systemwith a technological tie, and if the wholesale price of the essential component isinsufficiently remunerative, then there is a unique equilibrium outcome in whichthe supplier of the essential component invests alone and forecloses a more efficientrival with an actual, or merely threatened, technological tie. A comparisonof these equilibria for the two game forms demonstrates that a prohibition oftechnological tying can either increase or decrease social welfare depending onequilibrium selection.