Complementary Goods: Creating and Sharing Value

This paper studies the strategic interaction between firms producing strictly complementary products. With strict complements, e.g., video-game consoles and software titles, a consumer derives positive utility only when both products are used together. We show that when the products are developed by separate firms ("non-integrated" development) there exist both value sharing and value creating problems: firms charge higher prices and choose lower quality levels. Moreover, when the firms develop products sequentially the second mover has an advantage: it can choose a lower quality level and secure higher profits than the first mover. However, if the first mover can mandate a royalty or licensing payment from the second firm for permission to produce a compatible product (as often occurs in hardware-software arrangements), the profit advantage flips: the first mover captures a larger share of value created via a high licensing fee. When there is vertically differentiated competition in one of the product markets (e.g., two hardware firms of different quality and a single software firm), we show that with a royalty fee structure there is a possibility of a win-win-win situation where all firms are better off with the low quality firm in the market. This finding is in contrast to the extant literature that suggests that the low quality firm will always be driven out of the market. By shedding light on the incentives to improve quality and the effect of royalty fees, the analysis provides valuable insight for formulating marketing strategy in industries where consumption involves complementarities among multiple goods.