Game Analysis of Product Innovations Aimed at Differentiation in Markets with Network Externalities

A two-stage duopoly game model is proposed in markets with network externalities where firms compete in product innovation first and then quantity.  The product innovation is aimed at increasing product differentiation. First we investigate private optimum and analyze how network externality and compatibility affecting firms' incentives to invest. Then we study social optimum investment and compare the social and private incentives to product innovation for differentiation. The main results are as follows: (i) the firm with low marginal cost investing more than the one with high marginal cost may happen only when the market exists network externality and products have some compatibility between firms at the same time; (ii) when firms' marginal costs are equal, the private optimal R&D efforts increase with network strength and compatibility; But when firms' marginal costs are different, the optimal R&D effort of the firm with low marginal cost may decrease with network strength; (iii) the private incentive to provide product differentiation is lower than the social incentive.