Welfare Effects of Process Innovation in Two-Sided Markets: The Role of Compatibility Decisions


We analyze a two-sided market with cost-reducing R&D investments and compatibility decisions by two platforms. When the efficiency of investment is increased (i.e., process innovation has occurred), each platform has a heightened incentive to make its software incompatible with the rival’s hardware device to avoid being dominated in the hardware market, which leads to an inefficient market structure. The process innovation has not only positive direct effects of reducing costs but also negative indirect effects through the change of market structure by affecting the compatibility decisions. Hence we cannot simply infer that the process innovation is socially beneficial in two-sided markets.

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