Inefficient Standard Adoption: Inertia and Momentum Revisited

I. INTRODUCTION Since the establishment of the theory of network effects, economists have been concerned with the question of whether a market with network effects will tend to settle on the socially optimal standard. It has been postulated that markets may exhibit excess inertia: Once a technological standard is in place, a new, superior standard may not displace it because of installed base effects. Alternatively, markets may exhibit excess momentum: Consumers may adopt a new standard too quickly, ignoring the stranding effect they are having on previous users. Similar issues arise in the adoption of language and social norms. The literature has investigated various conditions under which one of these inefficiencies arises. Such inefficiencies are of particular concern for open technologies, such as the QWERTY and Dvorak keyboards. (1) The situation is somewhat different when individual firms own standards. In that case, a simple argument seems to indicate that there is no possibility that an inefficient standard will persist. If a new standard is superior in any objective sense, there are gains to be made from switching to it. Once the standard has been adopted, the firm can appropriate these gains. Therefore, the firm has incentive to lower the initial price enough to induce adoption of the standard. The preceding argument is made in Liebowitz and Margolis (1999) and repeated in Spulber (2002). Spulber expresses a general skepticism about the likelihood of inefficiencies when property rights are defined and markets exist. Critics might claim that previous models that imply inefficient standard adoption are unrealistic in some way, and that if such models were modified slightly, the inefficiency would disappear. I reconsider the issue of inefficient standard adoption using a parsimonious yet compelling model. Assuming only that there are successive generations of finitely lived consumers, that preferences are heterogeneous, and that there are network effects among users, adoption decisions can be inefficient. This is true even if consumers can coordinate efficiently within a generation and a firm can act as a coordinating device across generations. The model presented here generates some of the same results found in other papers collectively but in a more general setting and with more robust results. If there is an established standard and a superior alternative emerges, no single generation of consumers will be willing to switch to the new standard if the switching cost (the loss of network benefit from breaking with past users) is too high. It may be that the benefits to future generations of consumers are large enough that from a social standpoint it would be efficient for one generation to adopt the new standard, even if it is privately optimal for that generation to retain the old standard. On the other hand, the current generation considers only its own switching cost and not the cost it imposes on the previous generation, leading to potential overadoption of new technology. Even for proprietary standards, it is not clear that the incentive of the firm to induce adoption matches the social incentive. In particular, if consumer preferences are heterogeneous, the firm will not be able to price in such a way to extract all of the additional surplus gained from the new standard. On the other hand, the firm will be able to appropriate some of the surplus generated by the network effect itself, which is present for any standard and thus does not affect the social incentive to change standards. It is not possible to address this issue with a two-period model, as in some of the previous literature (see, for example, Choi, 1994; Choi and Thum, 1998; Katz and Shapiro, 1986). If a new technology is introduced in the second period but then the game ends, the welfare of future generations of consumers is neglected. (2) This article also differs from previous infinite-horizon models of technology adoption. …