Business Models and Compatibility Incentives

Abstract

This paper examines the compatibility incentives of two competing networks in a setting where the networks can choose fee-based or ad-sponsored business models and the sources of differentiation come from both network products and their users. In contrast to the prior literature, we find that the networks have no incentives to be compatible when they are both fee-based. The networks prefer compatibility when they are both ad-sponsored and the prevailing ad rate is high. Interestingly, after endogenizing the choices of business models, we find that the networks choose ad-sponsored business models in equilibrium even when they do not profit from ads. In addition, compatibility does not always improve user welfare. We also find that asymmetric choices of business models appear in equilibrium when one network has a significant installed-base advantage and the prevailing ad rate is low. In this case, the bigger network adopts a fee-based model, whereas the other adopts an ad-sponsored model, and the two networks stay incompatible.