Optimal quality choice under uncertainty on market development

Abstract

This paper analyzes the impact of risk and ambiguity aversion - Knightian uncertainty - on the choice of optimal quality and timing of market entry. Irreversibility of the investment in product development is introduced in a continuous-time stochastic model applying the real option literature. We consider a market characterized by a duopoly with a Stackelberg-Nash game for quality choice. When the follower provides a higher-quality good, the level of quality is decreasing in ambiguity aversion while it is a non-monotonic function of the level of risk. For low levels of risk, the increase of product quality is an efficient response. Up to certain threshold level of risk, risk and ambiguity aversion reduce the optimal quality level and increase the value of waiting when the follower supplies a higher-quality good. The implication is that risk and ambiguity aversion allow the leader to make a sustainable monopoly profit. When the follower supplies a lower-quality good, there is no value for it to wait. It should therefore provide the lowest-quality good possible. In a vertically integrated supply chain firms provide higher quality, and the difference between vertically integrated and non-integrated firms is increasing in risk and ambiguity aversion.