Dynamic Entry in Vertically Differentiated Markets
50 Pages Posted: 29 Nov 2016
Date Written: October 18, 2016
We develop a model of vertical innovation in which firms incur a market entry cost and choose a unique level of quality. Once established, firms compete for market shares, selling to consumers with heterogeneous tastes for quality. The equilibrium of the pricing game exists and is unique within our setup. Exogenous productivity growth induces firms to enter the market sequentially at the top end of the quality spectrum. A central feature of the model is that optimization problems of consecutive entrants are self-similar so that new firms enter in constant time-intervals and choose qualities that are a constant fraction higher than incumbent qualities. The asymmetries of quality choice, which inevitably arise because the quality spectrum has top and a bottom, is thus overcome by sequential entry. Our main contribution lies in handling these asymmetries.
Keywords: vertical differentiation, product quality, non-homogenous preferences, natural monopoly, endogenous growth, quality ladders
JEL Classification: A110, D430, L110, L130, O400
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