Economic Report President

Box 5-4.—Reverse Engineering and CompatibilityWhen competing network products are mutually compatible,consumers benefit from the same network externality regardlessof which product they choose. If the value of a word processingpackage depends on the number of people with whom documentscan be shared, then a new entrant can overcome its network disadvantageby enabling its product to exchange files with the leadingprogram. Similarly, if a new game platform can play cartridgesdesigned for rival systems, it gains value from the increased availabilityof complementary goods. Translation between systems isnot always perfect, however, and a dominant firm facing newrivals might try to reestablish its advantage by reintroducingincompatibility in subsequent versions of its software. Nevertheless,cross-compatibility remains an important competitivestrategy for entrants into network markets—and is beneficial forconsumers.To achieve compatibility, a competitor may have to “reverseengineer” the rival’s product, to learn how to make it work togetherwith its own. For that reason, firms with a market edge might tryto protect their products against efforts to establish cross-compatibilityby restricting competitors’ access to critical interfaces whereinformation is exchanged. One means of doing so is to enforce acopyright on the particular lines of computer code that a rivalwould have to use to make its product compatible. Courts, however,have been increasingly reluctant to uphold copyright protection forsuch purely functional aspects of computer programs. A leadingproducer may instead try to encrypt or otherwise technologicallyprotect the information to which a rival seeking compatibilityneeds access. The Digital Millennium Copyright Act of 1998expressly permits software developers to circumvent such protections.It thereby limits the extent to which a program copyrightcan block competition by noninfringing programs or in markets forcomplementary software. But to avoid undermining the incentiveto develop new software, the act allows circumvention only to theextent necessary to achieve compatibility.Second, these same switching costs can make network markets particularlyhard for new competitors to enter, especially if new productscannot interconnect with those already in the market. This potentiallymakes network monopolies quite stable and reduces the dominantfirm’s incentives to introduce innovative products and services. Anexample is the delay in the marketing of digital subscriber line (DSL)technology for high-speed telecommunications. Although DSL technologyhas been available since the 1980s, only recently did local telephone187