Platform Competition, Compatibility, and Social Efficiency

by Ramon Casadesus-Masanell & Francisco Ruiz-Aliseda

Overview — The last three decades have witnessed unprecedented growth in network industries such as video games, computers, credit cards, media, and telecommunications. These industries are often organized around physical or virtual platforms that enable distinct groups of agents to interact with one another, and are commonly referred to as two-sided markets or markets with two-sided platforms. An operating systems developer such as Microsoft, for example, provides a software platform that makes possible the completion of value-creating transactions between independent software vendors and users. A key attribute of the market that determines the intensity and scope of network effects is whether or not competing platforms are compatible. The effects of platform (in)compatibility on market outcomes, however, have largely been ignored by the literature on markets with two-sided platforms. This paper develops an explanation of why markets with two-sided platforms are often characterized by incompatibility with one dominant player that may choose to subsidize access to one side of the market. Key concepts include:

This paper provides a theory for why firms may choose to make their platforms incompatible.
Incompatibility might lead to market dominance and high profits by one of the platform providers, even if both providers are ex ante identical and there are no fixed costs of operation.

Author Abstract

In their seminal 1985 paper, Katz and Shapiro study systems compatibility in settings with one-sided platforms and direct network effects. We consider systems compatibility when competing platforms are two-sided and there are indirect network effects to develop an explanation why markets with two-sided platforms are often characterized by incompatibility with one dominant player who may subsidize access to one side of the market. Specifically, we model competitive interaction between two platform providers that act as intermediaries between developers of platform-based products (applications) and users of such products. We show that the unique equilibrium under platform compatibility leads to higher profits than the symmetric equilibrium under incompatibility. Notwithstanding, incompatibility naturally gives rise to asymmetric equilibria with a dominant platform that captures all users and earns more than under compatibility. Our model allows a detailed analysis of social efficiency, and we show that entry by developers is socially excessive (insufficient) if competing platforms are compatible (incompatible). We conclude that while society would be better off if platforms were compatible, the quest for market dominance by competing platform providers prevents them from agreeing to a common standard.