Static game model of a standard contest

The firm’s standardization decision will depend on the firm’s chances of winning a standards war against competing standards. The firm’s strategy for leading or following will depend on the relation between its own and other firms’ payoffs under the different outcomes. This standard contest will now be analysed in a static game model, where each firm’s strategic choices will affect the strategic choices of its competitors. Although a common standard is socially beneficial, the differences in firms’ payoffs may give rise to a conflict (Grindley 1995:33).

71 Assume that two firms have to decide whether to stick to their individual technology or switch to the other firm’s technology. The two players are Firm A and Firm B. Both firms can choose between leading, and hence setting the market standard, i.e. “Lead”, or adopt the other firm’s technology and standard, i.e.

“Follow”. The payoff each firm receives will depend on what choice the rival firm makes, and can be presented in a two-by-two payoff matrix. In each sell the payoff of each firm is indicated as (Firm A payoff , Firm B payoff).

Assume that compatibility is important to achieve through adoption of the same industry standard, for example that there would be little market demand unless firms agree on a common standard or that a standards battle would decrease a large proportion of potential profits. This can be illustrated in a “battle of the sexes” game. Here, the important outcome is that players agree to consistent strategies, i.e. one firm leads and the other follows, rather than fight. The payoffs for two competing firms, Firm A and Firm B, are listed according to whether they try to lead or follow (all payoffs in millions of dollars):

Firm B

LEAD FOLLOW

Firm A

LEAD ( 3 , 3 ) ( 6 , 4 )

FOLLOW ( 4 , 6 ) ( 0 , 0 )

Figure 8: Payoffs in “battle of the sexes” game (Grindley 1995:33)

If the two firms agree to one firm’s standard, the total payoff for the industry is

$10m. Then the firm that leads will receive $6m and the firm that follows will receive $4. With a leadership contest, i.e. both firms lead, the total payoff is only

$6m due to the standard war which reduces the total payoff. Here, each firm will receive $3m. These payoffs indicate that the firms are better off with one prevailing standard.

72 A Nash equilibrium occurs where neither firm has an incentive to change its strategy. In a one-shot version of this game, if Firm A leads, Firm B’s best response is to follow, where Firm A still prefers to lead. Thus, a Nash equilibrium is Firm A leads, Firm B follows, with payoffs (6 , 4). Another Nash equilibrium is Firm A follows, Firm B leads, with payoffs (4 , 6). Thus, both firms do better by agreeing on a single standard than fighting, but the firm that gets its commitment in first does better than the follower.

An interesting case is when the market would benefit from having a single standard, i.e. one firm leads and the other follows, but the distortions in payoffs in favour of the firm that leads is so great that the follower will prefer to risk a standards war. This is a form of the “prisoners’ dilemma” game. Here, all players would do better off agreeing, i.e. one lead and the other follows, but when each firm tries to gain an advantage at the expense of the other, they end up disagreeing to their mutual loss. The payoffs in this game can be illustrated in the following figure:

Firm B

LEAD FOLLOW

Firm A

LEAD ( 3 , 3 ) ( 8 , 2 )

FOLLOW ( 2 , 8 ) ( 0 , 0 )

Figure 9: Payoffs in “prisoners’ dilemma” game (Grindley 1995:34)

Compared to “the battle of the sexes” game, the distribution of the payoffs is now more in favour of the leader. The firm that leads will receive $8m, while the follower only receives $2m. If the firms agree on one standard the total industry payoff will be $10m, as before. If both firms lead, this gives each firm a payoff of

$3m, resulting in a total market payoff of $6. These payoffs indicate that the players jointly would do better by agreeing instead of fighting, but the follower’s payoff is too low for the firm to forego the chance of winning the standards contest.

73 If Firm B will choose to follow, Firm A will prefer to lead. However, if Firm A leads, then Firm B also will prefer to lead. This will result in the equilibrium outcome (3 , 3) and a standards war. Hence, total payoff in the market will only be

$6m, compared to $10m if they would agree to one standard. The outcome will therefore not be socially optimal.

A possible situation that would result in the “prisoners’ dilemma” game rather than the “battle of the sexes” game, might for example be in a network market where the market is “tippy”. In such a situation the outcome may be large gains for the winning standard. Thereby the firms may be willing to risk a standard battle which reduces their joint profits. The “tippyness” of network markets was illustrated in Figure 1.

However, Firm A (or Firm B) could ensure an agreement by changing the game, through committing to make side payments of $2m to Firm B (or Firm A) if the firm instead follows. In this case, the modified payoffs would be $6m to Firm A that leads and $4m to Firm B that follows, with the outcome (6 , 4) as in “the battle of the sexes” game. Such side payments could for example take the form of reasonable licensing terms of the technology constituting the leader’s standard. In the case when payoff differences are low it is less important whose standard is adopted. With no strong gains to be made by leading, the industry may agree on one standard. In such cases de facto standards may be established through market forces (Grindley 1995:34).

Open standards are also a way to alter the outcome of this game. An essential part of the logic behind open standards is that they may counteract the distortions in payoffs in favour of the firm that leads. By modifying the payoffs, the payoff of the leader and follower may be made more equal (Grindley 1995:35).

74