Investment in innovation in the presence of network economies.

Abstract

This research examines investment behavior within industries characterized by network economies. That is, industries in which the value of a product to consumers increases with the number of other consumers that purchase compatible products. I analyze indirect network economies by investigating the ability of firms, producing complementary products, to coordinate investment decisions over time. I also investigate the influence of direct network economies on the quantity-setting strategies of a durable good monopolist. When networks are present an incumbent technology has an advantage over an entrant, due to the value consumers place on an installed network of compatibility. This network can hinder the adoption of an innovation. Within industries characterized by indirect networks, strategic interdependencies exist as firms, who produce complementary products, invest in innovative technologies. Diffusion of innovations requires coordination, so that a new product might appear on the market accompanied by a minimal network of compatible complementary products. Game theoretic techniques are used to model this coordination process as it evolves over time. To determine if observed behavior is consistent with Nash refinements of selection among Pareto-rankable Nash equilibrium paths, economic experiments were conducted. The experimental data reveals that in a time-dependent multi-stage coordination game, subjects are unable to focus on the Pareto-dominant Nash equilibrium (PDNE) strategy path. However, given repetition subjects converge toward it. The data show that a higher cost of exiting the existing technology or a higher level of strategic uncertainty decreases the level of coordination on the PDNE strategy path. I also investigate the impact of a network parameter on a durable good monopolist's quantity-setting strategies. This two-period model reveals that the presence of network economies increases prices in both periods. Thus, the monopolist's profits increase relative to a model without network economies. Finally, I discuss how the combination of durability and network economies affect investment in incompatible product upgrades. When network economies exist, a firm must anticipate the interdependencies and uncertainties that exist among consumers. Thus, if sufficient demand for product quality exists relative to demand for network benefits, diffusion of the innovation should occur.