Investment In Product Quality Research Articles

Co-operative investment by downstream rivals: network sharing in telecom markets

Ever-increasing data consumption and evolving technologies make cooperation on investments and network sharing crucial issues in mobile telecommunications markets. In this paper, we analyze incentives for cooperation and investment in product quality. Generalizing quality investment in a Hotelling duopoly model, we allow investment to have heterogeneous effects on consumers’ changing demand responsiveness to prices. If the effect of investment on demand elasticity is weak, consumer surplus and total welfare are higher when firms are prevented from cooperating on quality investment. Otherwise, firms should be allowed to jointly decide on quality improvements and share these improvements as long as they compete in the downstream markets.

Experience Goods and Consumer Search

We introduce a search model where products differ in horizontal attributes and unobserved quality (“experience goods”), and firms can establish quality reputation. We show that the inability of consumers to observe quality before purchase significantly changes how search frictions affect market performance. In equilibrium, higher search costs reduce match values and increase price but can boost firms’ investment in product quality. Under plausible conditions, both consumer and total welfare initially increase in search cost, whereas both would monotonically decrease if quality were observable from search. We apply the analysis to online markets, where low search costs coexist with low-quality products. (JEL D11, D21, D83, L15)

Optimal certification policy, entry, and investment in the presence of public signals

AbstractWe explore the optimal disclosure policy of a certification intermediary where (i) the seller decides on entry and investment in product quality, and (ii) the buyers observe an additional public signal on quality. The optimal policy maximizes rent extraction from the seller by trading off incentives for entry and investment. We identify conditions under which full, partial or no disclosure can be optimal. The intermediary's report becomes noisier as the public signal gets more precise, but if the public signal is sufficiently precise, the intermediary resorts to full disclosure. However, the social welfare may reduce when the public signal becomes more informative.

A Note on Endogenous Market Structure under Heterogeneous Firms*

Industries, such as semiconductors and biotechnology, are characterized by heterogeneous research productivity and vertically differentiated products. In this note, I relax the assumption of symmetric R&D costs in Sutton [1998] and derive the lower bounds to market concentration when entry and R&D investments in product quality are jointly determined. I show that the lower bound to concentration depends on the degree of vertical differentiation, which is a function of market size and quality choices. My findings imply that empirical applications that fail to account for differences in quality will be biased towards the null hypothesis of exogenous entry costs otherwise.

A Bayesian approach to estimation of dynamic models with small and large number of heterogeneous players and latent serially correlated states

We propose a Bayesian approach to estimating dynamic models that can have state variables that are latent, serially correlated, and heterogeneous. Our approach employs sequential importance sampling and is based on deriving an unbiased estimate of the likelihood within a Metropolis chain. Under fairly weak regularity conditions unbiasedness guarantees that the stationary density of the chain is the exact posterior, not an approximation. Results are verified by Monte Carlo simulation using two examples. The first is a dynamic game of entry involving a small number of firms whose heterogeneity is based on their current costs due to feedback through capacity constraints arising from past entry. The second is an Ericson and Pakes (1995) style game with a large number of firms whose heterogeneity is based on the quality of their products with firms competing through investment in product quality that affects their market share and profitability. Our approach facilitates estimation of dynamic games with either small or large number of players whose heterogeneity is determined by latent state variables, discrete or continuous, that are subject to endogenous feedback from past actions.

R&D Concentration Under Endogenous Fixed Costs: Evidence from Genetically Modified Corn Seed

AbstractWe examine the role of fixed costs in research and development (R&D) in the market for genetically modified (GM) corn seed. In a mixed model of horizontal differentiation by genetic traits and vertical differentiation by productivity, we derive the empirically testable lower bounds to R&D concentration when R&D investments and market entry are jointly determined. When R&D investments translate into higher product quality, industries are said to be characterized by endogenous fixed costs such that the lower bound to R&D concentration increases with market size, but is less than the lower bound to market concentration based on sales. Using data on field trial applications of GM corn seed, we estimate the lower bound to R&D concentration, and find evidence of endogenous fixed costs with R&D concentration that is significantly greater than perfectly competitive levels. These endogenous fixed costs imply that concentration in the agricultural biotechnology industry is occurring due to the nature of R&D investment in product quality and not through anticompetitive practices. Adjusting for past merger and acquisition activity significantly raises the lower bound for infinitely‐sized markets, but has no impact upon current market sizes, implying the industry may still undergo additional consolidation.

Quality upgrading and price heterogeneity: Evidence from Brazilian exporters

This paper uses producer quality information to investigate whether firms segment markets and adapt product quality and prices according to destination country characteristics. Using detailed price and quality data for Brazilian exporters over time, the results document quality-based market segmentation, by which firms raise quality and prices to high-income destinations. A major exchange rate shock and further robustness analysis reinforce the hypothesis that adjustments in quality and prices happen within the firm and that differences in prices across destinations may be driven by investments in product quality and demand for high quality.

A Theory for Regulation of Essential Products

This essay introduces an innovative framework for consumer protection, based on consumers’ basic needs. Current contract law is based on a binary model: contracts which lack consent are considered void and are not enforceable under the unconscionability doctrine. Yet, voluntariness is not binary. Rather, voluntariness is a hierarchical continuum reflecting human needs. Certain products are purchased because the consumer has to have them, while other products are purchased as a discretionary consumer choice. Current law does not make the distinction between essential and non-essential markets. Consumers of luxuries and consumers of essentials are considered equal, and receive similar legal protection under the contractual framework of the consumer transaction. This essay offers a theory of essential markets and their regulation. The essay surveys the behavioral literature discussing human needs and the distinction between essentials and luxuries, and applies the needs-based theory to consumption, creating a pyramid of markets following Maslow’s hierarchy of needs. The essay identifies the determinants of market essentiality, including a moral baseline of consumption; lack of good substitutes and inability to decline purchase; and time constraints creating difficulty to defer purchase. The continuum of market essentiality is then demonstrated using four examples, including electricity for heating, infant formula, broadband services, and a violin. The essay argues that essential needs-based consumption induces a behavioral market failure, where consumers' decision-making process is particularly vulnerable and distorts sellers' incentives towards a sub-optimal equilibrium. Markets of essentials tend toward failure of demand, due to consumers’ bounded voluntariness and lower probability of informed choice. Accordingly, sellers in markets of essentials have higher incentives for collusion and lower incentives for price competition and for investment in product quality. Thus, the likelihood of market failure increases with the essentiality of the product: the more basic the underlying need, the higher the probability for market failure. The difficulty of regulators to tell which markets are essential is addressed. The essay suggests two methods for assessment of essentiality - the first, through political assessment, and the second, through analysis of market data documenting elasticity of demand for popular product categories. Low elasticity of demand for popular product categories is proposed as a market signal for consumers’ bounded voluntariness and for product essentiality. The normative implications of this structural division of markets are discussed and initial policy guidelines suggested. Essentiality and its tendency to create a behavioral market failure implies that consumer law should be structured with a hierarchy of rights, similar to constitutional or international human rights laws. Essential products should be subject to a higher degree of paternalism compared with non-essentials.

Competition and product innovation in dynamic oligopoly

We investigate the relationship between competition and innovation using a dynamic oligopoly model that endogenizes both the long-run innovation rate and market structure. We use the model to examine how various determinants of competition, such as product substitutability, entry costs, and innovation spillovers, affect firms' equilibrium strategies for entry, exit, and investment in product quality. We find an inverted-U relationship between product substitutability and innovation: the returns to innovation initially rise for all firms but eventually, as the market approaches a winner-take-all environment, laggards have few profit scraps to fight over and give up pursuit of the leader, knowing he will defend his lead. The increasing portion of the inverted-U reflects changes in firm's investment policy functions, whereas the decreasing portion arises from the industry transiting to states with fewer firms and wider quality gaps. Allowing market structure to be endogenous yields different results compared to extant work that fixes the market structure.

Competition and Product Innovation in Dynamic Oligopoly

We investigate the relationship between competition and innovation using a dynamic oligopoly model that endogenizes both the long-run innovation rate and market structure. We use the model to examine how various determinants of competition, such as product substitutability, entry costs, and innovation spillovers, affect firms' equilibrium strategies for entry, exit, and investment in product quality. We find an inverted-U relationship between product substitutability and innovation: the returns to innovation initially rise for all firms but eventually, as the market approaches a winner-take-all environment, laggards have few profit scraps to fight over and give up pursuit of the leader, knowing he will defend his lead. The increasing portion of the inverted-U reflects changes in firm's investment policy functions, whereas the decreasing portion arises from the industry transiting to states with fewer firms and wider quality gaps. Allowing market structure to be endogenous yields different results compared to extant work that fixes the market structure.

Bundling, Competition and Quality Investment: A Welfare Analysis

We investigate how bundling affects investment in product quality, and derive welfare implications. A monopolist in a primary market competes with a rival in a complementary market. Bundling is the monopolist’s preferred strategy, since it either extracts surplus from the rival’s investment, or forces the rival to provide low quality. Bundling may reduce welfare without foreclosing the rival, but improves welfare when preventing undesirable investment. Since prohibiting bundling is not appropriate, we introduce a price test for bundled offers that preserves efficiencies from both bundling and quality investment, thereby improving welfare relative to the ‘do-nothing’ scenario. We consequently argue that this test should be applied whenever possible.

How can New Ventures Build Reputation? An Exploratory Study

In this paper, we explore the processes and mechanisms of reputation-building by new ventures (NVs), using a grounded theory-building approach from case studies. Based on interviews with experienced entrepreneurs, supplemented by secondary data on their NVs, we identify several types of activities that may help NVs build their initial reputations. We find that NVs accumulate one of two types of reputation: generalized reputation with large groups of distant stakeholders or local reputation with a small group of local stakeholders. Our analyses suggest that using symbolic activities, as well as investments in human capital and social capital may help an NV accumulate generalized reputation, whereas investments in product quality together with building close relationships with customers may help an NV build local reputation. What type of reputation an NV would try to achieve and what activities it would emphasize appear to be related to the type of product that the NV offers.

Delayed multiattribute product differentiation

We develop a two-stage model for versioning products with respect to both vertical and horizontal attributes. At first, a firm positions its top-quality “flagship” product in a market with an imperfectly known distribution of tastes and reservation prices. In the second stage, the firm learns these consumer characteristics and has the option of extending its product line by versioning the flagship product using pure horizontal differentiation, quality degrading, or both. The firm's nonconvex versioning problem is solved analytically for the two-product case. We find that ex ante extending the product line through vertical differentiation is optimal for low marginal cost of quality (development cost); otherwise pure horizontal differentiation is superior. Given quasilinear consumer preferences and a uniform distribution of consumer characteristics, versioning with respect to both horizontal and vertical attributes is never optimal. Under delayed differentiation the optimal policy is contingent on the observed demand realization and may lead to horizontal cannibalization and price dispersion for equal-quality products. The firm tends to increase its investment in product quality unless it adopts a state-contingent policy of horizontal versioning for high and vertical versioning for low demand realizations. Following a state-contingent policy, the optimal upfront development effort may be significantly lower than under full ex-ante commitment. The option value of delayed differentiation is generally nonmonotonic in the firm's development cost.

Collusion and dynamic (under‐) investment in quality

In a dynamic game of investment in product quality, I investigate whether collusive underinvestment equilibria can be supported by the threat of escalation in investment outlays. When there are no spillovers, underinvestment equilibria exist even though, by deviating, a firm can gain a persistent strategic advantage. When there are strong spillovers, underinvestment equilibria fail to exist. A weakening of patent protection can thus lead to more investment in equilibrium. A “nonfragmentation” result is shown to hold: in all free‐entry equilibria, industry concentration is bounded away from zero, no matter how large the market, and despite the existence of underinvestment equilibria.

Multinational corporations and export quality

We investigate the effects of spillovers on quality of exports emanating from investment in product quality by multinational corporations, operating in less developed countries. By using a duopoly set up, we show that under price competition these spillovers enhance the quality of exports by less developed countries. We also show that this result is valid under quantity competition.

Is Bigger Better? Customer Base Expansion through Word‐of‐Mouth Reputation

A model of gradual reputation formation through a process of continuous investment in product quality is developed. We assume that the ability to produce high‐quality products requires continuous investment and that as a consequence of informational frictions, such as search costs, information about firms’ past performance diffuses only gradually in the market. This leads to a dual process of growth of a firm’s customer base and an increase in the firm’s investment in quality. The model predicts, therefore, that the longer its tenure as a high‐quality producer, the more a firm invests in quality. We relate this finding to empirical work on online commerce as well as on traditional industries.

The effect of subsidies to product innovation on international competition*

Models of vertical product differentiation allow for the analysis of international trade in the presence of country asymmetries in terms of product qualities, technology, costs, market size, and income. In the presence of such asymmetries, national industries will either be market leaders or be lagging behind in the international market place in terms of their product qualities. The resulting asymmetry in profits creates powerful incentives for lagging industries as well as their national governments to reverse this situation to their advantage, i.e. to induce "leapfrogging" in terms of product qualities. This paper presents an analysis of subsidies to investment in product quality as a facilitating device for leapfrogging. Investment in product quality is interpreted as innovation investment or expense, which includes but is not limited to R&D investment. Its result is a better, different product, i.e. product innovation. It is found that subsidies to quality investment can induce leapfrogging and thereby increase domestic profits, consumer surplus and welfare. In the case of leapfrogging, the domestic firm will enjoy profit increases that are larger than the necessary subsidy costs. The strategic aspect of the subsidy policy lies in its function as a facilitating device for a radical change of the initial market structure, where the domestic firm gains an international leadership position.

Cartel stability in advertising-intensive and R&D-intensive industries

Collusive pricing by firms producing a vertically differentiated product is less likely the larger the `quality' difference between them, because, as one firm increases its investment in product quality or brand image, a low-spending rival is increasingly unlikely to adhere to a collusive arrangement. This result is robust to whether firms set prices or quantities and may explain the low occurrence of collusive pricing in advertising-intensive and R&D-intensive industries.

Investments in product quality: A descriptive study of the US optical fiber industry

This paper attempts, in a descriptive fashion, to foster an understanding of the character and magnitude of investments to achieve quality by firms in the optical fiber industry. Based on survey data from all US firms and from a representative sample of international companies, it appears that, among other things, US firms invested a larger percent of their budgets toward quality-related objectives in the 1980s than did their foreign counterparts. This might explain, in part, why US producers of optical fiber dominate the world market when many other technology-based industries are losing their share of the world market.

Product innovation and contestability

This article deals with the introduction of product innovation in a contestable market model. Investment contestability describes a benchmark case of competition by introducing sunk entry-deterring investment in a free entry framework. Aside from careful price setting, suppliers adopt investment in product quality in order to deter entry. Zero-profit pricing and increased quality point to a partial second-best outcome of market behaviour.