The Strategic Value of Flexible Quality Choice: A Real Options Analysis

Abstract

This paper studies the effects of demand uncertainty and imperfect competition on market entry and product quality choice. We develop a dynamic duopoly model allowing for either a fixed or a flexible quality choice. We find that under the fixed quality choice the follower chooses a higher quality provision. The quality provision is shown to generally increase with the level of demand volatility. The strategic choice of quality provision by the follower may result in the exit of the first mover. Furthermore, flexibility in quality choice of the pioneering firm can constitute a strategic disadvantage. Finally, our results show that the degree of horizontal differentiation between the supplied goods plays a pivotal role in determining the market structure in the long-run.