Avoiding market dominance: product compatibility in markets with network effects

TLDR

Market dominance is a common outcome in network‑effect markets, where a larger installed base makes a product more attractive, attracting more consumers and further enlarging the advantage. This study examines how firms can mitigate dominance by choosing product compatibility. When firms have comparable installed bases, they adopt compatibility to expand the market, but if one firm gains a larger base, it may opt for incompatibility. Strategic pricing can curb the growth of installed‑base disparities, preventing incompatibility and thereby neutralizing increasing returns to avoid market dominance.

Abstract

As is well recognized, market dominance is a typical outcome in markets with network effects. A firm with a larger installed base offers a more attractive product which induces more consumers to buy its product which produces a yet bigger installed base advantage. Such a setting is investigated here but with the main difference that firms have the option of making their products compatible. When firms have similar installed bases, they make their products compatible in order to expand the market. Nevertheless, random forces could result in one firm having a bigger installed base, in which case the larger firm may make its product incompatible. We find that strategic pricing tends to prevent the installed base differential from expanding to the point that incompatibility occurs. This pricing dynamic is able to neutralize increasing returns and avoid the emergence of market dominance.