When Less can be More: Setting Technology Levels in Complementary Goods Markets

Higher technological quality often directly translates into higher consumer utility. However, many new products require the availability of a complementary product. In such markets, releasing a technologically sophisticated product involves a tradeoff as it excludes consumers whose complementary products no longer function with the core product. Firms therefore have to balance product quality against market size. Technological change brings a dynamic perspective to this tradeoff as it renders existing technology obsolete but also increases performance of the complementary products, therefore increasing market potential. We study these mechanisms in the empirical context of computer games. In line with our expectations, we find an inverted U-shaped relationship between closeness to the frontier and sales revenues as well as differential effects of technological change depending on initial technological quality.