January 2000
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This paper looks at a hardware firm's decision to make its products forward and backward compatible in a model with heterogeneous consumer preferences. First, looking at a competitive hardware market, we show that backward compatibility always increases the valuation of hardware by the marginal consumer (who has the lowest valuation among purchasers of the new hardware), but backward compatibility can reduce the valuation of higher consumer types. Next, we look at a monopoly case. The effect of backward compatibility on the profit of the monopolist depends on how consumers substitute between old and new software programs and how sensitive the number of programs is to consumers' expenditures. The final part of the paper considers the case where the hardware firm has an option to employ an 'open licensing contract' on the software market, as is common in the video game industry. In this case, the firm uses the combination of the hardware price and a licensing fee to price discriminate between different consumer types. We study how compatibility decisions affect the price-discrimination scheme. to the participants of the Harvard Industrial Organization seminar and those of the Harvard Theory seminar. I thank Drew Fudenberg for guidance and support. All errors are my own.