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Increasing compatibility as a competitive tool (RV of 2003/41/MKT)

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When designing a new product (or service), managers often need to make decisions related to the product's compatibility with existing competitive products. Naturally, compatibility is important where network effects are significant. However, even in categories without network effects, such as "Do It Yourself" products (paint, flooring and bathroom fittings), photographic equipment, and tax preparation software, the compatibility of a first purchase with a subsequent one may be important for buyers. The authors develop a model of such 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. Their key finding is that investments in compatibility often lead to increases in firm profits: there is an incentive for firms to make it easy for existing consumers to switch to competitive products. However, the incentive structure is such that, frequently, these investments are not made. In other words, a problem of coordination leads to lower firm profits and lower total welfare. Interestingly, when firms make product design decisions sequentially, or when firms can cooperate in the product design stage, the likelihood of a market with compatible products is much higher. This highlights the need for governments to encourage cooperation and disclosure during the design stage.

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