Quantifying and mitigating inefficiency in information acquisition under competition

Abstract

This paper analyzes a horizontally differentiated product market in which firms acquire costly information about the stochastic market. Our results provide guidelines to government agencies on regulating information acquisition. We show that firms overinvest in acquiring information only when information acquisition is particularly cost-effective. Otherwise, underinvestment could occur even under very intense horizontal competition. Moreover, it is underinvestment in information acquisition that is more damaging to firms. Using a linear cost function, we demonstrate that the loss in return on investment caused by horizontal competition can be at least one-third of the first-best return on investment. If the degree of competitive intensity and demand variation decrease, or the marginal cost increases, information acquisition will become increasingly inefficient. We further find that firms benefit from agreeing in advance to exert the same investment level and strategically invest less than the competitive equilibrium level, which can benefit consumers as well. Industry associations are therefore recommended to facilitate effective communication between firms.