Network effects encourage original equipment manufacturers (OEMs) to expand their market size by changing their relationships with third-party manufacturers who provide compatible products from competition to coopetition. Moreover, network effects render consumer valuation inherently dynamic. Consumer perceptions of the sales quantity are continuously updated, causing the impact of the network effect to change dynamically over time. To this end, we examine technology licensing and price competition in a dynamic duopoly including an OEM and a third-party manufacturer, considering that consumer utility increases with the dynamic and evolving impact of network effects. However, because of limited product technology, the lower compatibility of third-party products reduces network effects. Thus, the third-party manufacturer licenses technology from the OEM. Because the OEM can strategically choose a static or dynamic royalty under technology licensing in a dynamic pricing game, we derive the firms’ subgame-perfect Nash equilibrium decisions and profits and analyze the effects of licensing mechanisms and market factors on firms’ instantaneous and steady-state equilibrium decisions and profits. Technology licensing enhances firms’ profits when firms’ and consumers’ dynamic behaviors are more significant by exerting stronger network effects. A dynamic royalty is more effective for mitigating price competition intensity and for helping firms maintain higher sales margins. A static royalty induces a lower royalty chosen by the OEM and firms lower prices, which increases the impact of network effects and thus is generally more advantageous for the firms and for social welfare.

Introduction

In many markets, increases in the market sizes of certain products enhance communication among consumers and lead to a greater variety of complementary products offered, improving consumer demand for the products. These products are said to generate network effects (network externalities) that enhance the utility of a product for a consumer due to an increasing number of consumers who purchase similar products (de Palma, Leruth, & Regibeau, 1999). Many studies (e.g., Alexandrov, 2015; Chen, Doraszelski, & Harrington, 2009; Clements, 2004; Grajek, 2010; Katz & Shapiro, 1985; 1994; Malueg & Schwartz, 2006; Rasch, 2017; Wang, Chen, & Xie, 2010) have noted that product compatibility is a fundamental issue that influences network effects. For example, Grajek (2010) indicated that low compatibility reduces network effects based on empirical evidence from mobile markets. Based on empirical data from 45 product categories, Wang et al. (2010) verified that lower product compatibility has a negative impact on network effects. Moreover, network effects are important factors for OEMs (original equipment manufacturers) because they encourage the entrance of third-party manufacturers that sell substitutable and compatible products. Due to the limitations of the available technology, the strength of network effects on third-party products, as perceived by consumers, is often positively related to the product technology achieved by third-party manufacturers. This phenomenon is common in the consumer electronics and software industries. Using the lenses of digital reflex cameras as an example, third-party manufacturers (e.g., Sigma, Tamron, and Tokina) provide lenses that are compatible with those provided by an OEM (e.g., Canon, Fujifilm, Nikon, and Sony), and they compete in the market such that the availability of the third-party lenses improves consumer utility and subsequently increases the market demand of the OEM products.