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Increasing compatibility as a competitive tool

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A key question for many managers when designing a new product or service is how compatible the products should be with existing competitive products. These issues are particularly important where network effects are significant, i.e. the benefits of using the product are related to how many other people are using the same product (Farrell and Saloner 1986). However, for an individual consumer, the benefit of buying a product in the present may also be linked to the benefits of purchase and consumption in the future. In categories such as "Do It Yourself" products (paint, flooring and bathroom fittings), photographic equipment, tax preparation software, and learning methods for musical instruments, the compatibility of a first purchase with a subsequent purchase may be an important issue for buyers. These are product categories where between-brand switching costs are endemic and firms can make non-recoverable investments in product design to increase the compatibility of their products with others in the market. The authors investigate this topic using a model where two single-product firms make simultaneous investments to design products that are fully compatible with the competitor's. The key finding is that firm profits can be increased significantly if the investments are made. That is, as long as the ex ante investment is not too high, a firm has an incentive to make it easy for an existing consumer to switch to a competitive product in the future. However, the incentive structure to make the investments is such that frequently, the investments are not made. In these situations, both firm profits and total welfare are decreased due to product incompatibility. Interestingly, when the product design decisions are sequential or when firms can cooperate in the product design stage, the likelihood of a market with fully compatible products is much higher. This highlights the need for government to encourage cooperation and encourage disclosure during the design process in markets where switching costs are endemic.

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en

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application/pdf

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http://flora.insead.edu/fichiersti_wp/inseadwp2003/2003-41.pdf

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Copyright INSEAD. All rights reserved