"Mix and Match": Product Compatibility without Network Externalities

In industries where consumers can assemble their own systems, firms must decide whether to make their components compatible with those of their rivals. We examine a two-stage game in which two fully integrated firms make their compatibility decisions before competing in prices. The symmetric perfect Nash equilibrium of this game is shown to involve full compatibility. Although compatibility leads to higher prices than incompatibility, it also increases the variety of systems available so that some consumers are better off with compatibility, while others are hurt. If standardization is costless, compatibility increases social surplus but may decrease consumer surplus.