Excess Intertia and Cross-Model Validation

A Game-Theoretic Model of Switching Standards

Network Externalities have been treated in a wide variety of ways across the field. Some researchers offer mathematical models that are quite different from the model we chose to implement in this tutorial. "Standardization, Compatibility, and Innovation" by Joseph Farrell and Garth Saloner (RAND Journal of Economics, Volume 16, Issue 1 - Spring, 1985, 70-83) discusses a two-stage game-theoretic model in which two firms try to decide whether to switch from an inferior to a superior standard.

Without going into detail, the Farrell and Saloner game works roughly as follows: A firm's profit depends on whether it uses the inferior or superior standard and on whether the other firm uses the same standard. The superior standard generally tends to increase profit, but compatibility with the other firm also increases profit by some amount. Because of this, a typical firm is best off when both firms switch to the superior standard, somewhat worse off if both firms adhere to the inferior standard, and even worse off if the firms select different standards, though in the last case it is usually better to be the firm with the higher standard.

If every firm faced these typical payoffs, it would always be profitable to switch to the superior standard. The firms would face a simple, but rather uninteresting, coordination game. Suppose, however, that firm payoff functions vary, so some firms actually prefer the inferior standard (perhaps a certain firm faces high costs of retraining its employees). Suppose further that a firm's payoffs are private information, so neither firm knows what the other firm will do. Then each firm must attempt to predict the other firm's behavior when deciding whether or not to switch to the superior standard. If a firm switches to the superior standard, but the other firm does not follow, both firms loose profit.

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