Quality competition and product compatibility in network industries

This paper investigates the interplay between product compatibility and quality competition in network industries. Our findings indicate that when firms have veto power over product compatibility, high network externalities inevitably lead to incompatibility, making compatibility unattainable. Without veto power, however, compatibility always emerges. This suggests that patent protection may impede compatibility, particularly in the presence of significant network externalities. Moreover, our results highlight the benefits of compatibility, including improved product quality, higher profits, increased consumer surplus, and overall welfare. We further demonstrate that an increase in externalities boosts product quality when products are compatible but reduces it when they are incompatible, while expanding vertical product differentiation in both cases.