Abstract:

In the presence of a positive indirect network externality (INE), the value of a hardware increases with the availability of software. Hardware manufacturers can thus gain competitive advantage by increasing the availability and variety of compatible software. When software and hardware manufacturers are not integrated (e.g., Video game industry), hardware makers (e.g., Sony, Nintendo, Microsoft), enter into a contract with independent software makers (e.g. Capcom, Rockstar) that stipulates whether or not the software should be exclusive to (i.e., compatible only with) the contracting hardware. An exclusive contract lets the INE advantage to remain with the contracting hardware maker. However, because an exclusive contract limits the market size for the software maker, a discount in royalty is given by the hardware manufacturer to the software maker.

In my dissertation, I use a game theoretical approach to study hardware manufacturer's decisions on software exclusivity and royalty contracts. Assuming a market with two hardware manufacturers with incompatible hardware platforms and a single software publisher and a single-period game, this paper examines the conditions under which an exclusive or a non-exclusive contract is optimal. The major findings are as follows: (1)?Hardware manufacturers' exclusivity decisions: When INE effect is strong, hardware manufacturers consistently prefer using exclusive titles. However, when such effect is small and there is no strong substitution effect in the software market, both firms will favor Non-exclusive titles. (2)?Hardware manufacturers' royalty rates decisions: In general, hardware manufacturers will reduce royalty rates when the software market is price sensitive. Furthermore, the INE effect may also affect hardware manufacturers' decisions on royalty rates. (3)?Hardware manufacturers' discount rates decisions: When consumers prefer software variety, the hardware manufacturer will offer a positive discount for her exclusive software title.

This research incorporates the INE effect into hardware manufacturer's exclusivity and pricing strategies. The results of this paper highlight some important managerial insights for hardware manufacturers and could be generalized into other industries where INE effect exists.