Model Of Vertical Product Differentiation Research Articles

Competing to Sell the Reference Product

In a sequential model of vertical product differentiation in which consumers are loss-averse, I analyse how firms compete to sell the reference product when they set prices. I find that there are two subgame perfect equilibria: one where the reference point for all consumers is the higher-quality product; and the other where the reference point is the lower-quality product. However, applying the risk-dominance criterion, I obtain that the sole risk-dominant equilibrium is for the higher-quality firm to sell the reference product. Since the hedonic price of the higher-quality product is the highest, consumers do not suffer any psychological disutility in the risk-dominant equilibrium.

Close But Not Too Close? Optimal Copycat Strategies in the Light of Negative Publicity by the Original Product

Abstract This paper contributes to the understanding of how brand scandals related to a brand leader’s product affect the follower firm’s choice between copycatting and independent product development. In a model of vertical product differentiation, we show that it is optimal for the copycatter to follow a ‘safe distance’ strategy which guarantees a certain degree of protection against the negative spillovers associated with a brand scandal to the leader. Nevertheless, when the follower firm can choose between copycatting and decoupling, it chooses a higher quality for its copycat product because of the lower development costs. The decision for or against copycatting thus depends on a trade-off between development costs and the possibility of negative spillovers. Finally, we show that the threat of a scandal can lead to an additional indirect welfare cost because it diverts the follower’s choice away from a welfare-maximizing copycat strategy.

Market for artificial intelligence in health care and compensation for medical errors

We study the market for AI systems that are used to help to diagnose and treat diseases, reducing the risk of medical error. Based on a two-firm vertical product differentiation model, we examine how, in the event of patient harm, the amount of the compensation payment, and the division of this compensation between physicians and AI system producers affects both price competition between firms, and the accuracy (quality) of AI systems. One producer sells products with the best-available accuracy. The other sells a system with strictly lower accuracy at a lower price. Specifically, we show that both producers enjoy a positive market share, so long as some patients are diagnosed by physicians who do not use an AI system. Any transfer in compensation payment from the physician to the AI producer in the case of a diagnostic error will be passed on in full to the physician via the price of the AI system. The quality of the AI diagnosis system is independent of how any compensation payment to the patient is divided between physicians and producers. However, the magnitude of the compensation payment matters. An increase in compensation increases demand for both AI systems. In addition, the higher the compensation paid to the harmed patient, the higher the quality of the low-quality AI system. As the other firm continues to offer the highest accuracy level, any increase in compensation will decrease vertical differentiation, thereby increasing price competition between firms.

Dumping, antidumping duties, and price undertakings

This paper examines which types of firms, from a developed country (DC) or a less developed country (LDC), tend to practice dumping, using a two-market equilibrium analysis of trade in similar products. Specifically, we present a vertical product differentiation model of duopolistic competition between a DC firm and an LDC firm under free trade to show that the DC firm sells a higher-quality product without dumping. In contrast, the LDC firm sells a lower-quality product and practices dumping in the DC market by charging a price lower than the product's price in the LDC's local market. In response to the LDC dumping, the DC government's use of an optimal antidumping duty increases its domestic welfare. The LDC's social welfare may increase if its exporting firm accepts price undertaking rather than dumping. From the perspective of world welfare, defined by aggregating the welfare of the trading countries (DC and LDC), the trade damage measure through imposing antidumping fines on LDC dumping is Pareto-improving compared to free trade (under which dumping takes place) and price undertakings.

Input price discrimination, pricing contract and social welfare

In this paper, we introduce input price discrimination into vertical product differentiation model to analyze the impact of input price discrimination on social welfare. We find that the input price discrimination improves the supply of high-quality products in the market, and lead to the increase of consumer surplus. The effect of input price discrimination on social welfare is influenced by the pricing contract of input. When the price of input is determined by upstream firm, the input price discrimination reduces social welfare. While the input price discrimination increases social welfare when the price of input is determined by bargaining of upstream and downstream firms.

Is it rational for a large-retailer to sell an own-brand product similar to the branded product of a large manufacturer? A Vertical Product Differentiation Model

A theoretical model was constructed to investigate the conditions that a large retailer must satisfy to increase the quality of the retailer-owned brands towards a greater number of groceries. The key result shows that the restraint given by a vertical integration scheme (producer-distributor) is relaxed for a higher quality-production cost ratio under the assumption of modelling with endogenous quality. Another finding is that the national brand´s production is not altered, which is explained by the fact that this brand is demanded by consumers with high willingness to pay for it. However, the wholesale price decreases and hence the manufacturer’s profit always falls as the quality of own brands rises. This is consistent with the argument that the retailer improves its negotiation capacity with the private manufacturer when it sells an own brand that is a close substitute for the manufacturer’s label, which always forces the wholesale price of the branded product down.

Quality Competition and Market-Share Leadership in Network Industries

Abstract This paper incorporates network externalities into a model of vertical product differentiation to examine how firms determine product quality and network size. We show that, with significant network benefits from quality improvement, the effects of network externalities differ depending on the type of competition. In response to an increase in network externalities, vertical product differentiation enlarges under price competition but shrinks under quantity competition. Moreover, under price competition, the network size of a high-quality product increases, whereas that of a low-quality product decreases for a sufficiently large extent of network externalities, resulting in a reversal in the leading position in terms of network size from the low- to the high-quality product. By contrast, the network sizes of high- and low-quality products both increase under quantity competition; moreover, the gap between their network sizes shrinks for a sufficiently large extent of network externalities.

Revenge consumption, government‐led voucher, and social welfare

This paper considers revenge consumption and government vouchers directly provided to the consumers in a duopoly model of vertical product differentiation. We find that revenge consumption will raise consumer surplus and social welfare. The government issuing vouchers will further push up consumer surplus and social welfare; however, facing the wave of revenge consumption, the government purposely want to recover the slowdown economy caused by the pandemic spread-out, should fully consider the quality difference of products and issue different discount rate voucher. For the producer, whether the government issuing vouchers increase firm's profit depends on the degree of revenge consumption and product differentiation.

FDI and quality-enhancing technology spillovers

When Northern firms undertake FDI in the South, their superior technology spills over to Southern firms and enables Southern firms to enhance their product quality. This paper explores quality-enhancing technology spillovers in an international duopoly model of vertical product differentiation. We find that the Northern firm strategically reduces its product quality to limit the amount of technology spillovers upon FDI. The trade-off between the Northern firm’s endogenous product quality choice and technology spillovers—similar to that between R&D and technology spillovers as discussed previously–plays a critical role in welfare consequences and policy implications of quality-enhancing technology spillovers.

Revenge consumption, product quality, and welfare

Revenge consumption, the situation in which the demand for specific goods and services suddenly skyrockets and remains high for an extended period of time, is a relatively new economic phenomenon observed recently in many cities around the world after the easing of restrictions associated with the coronavirus pandemic in 2020 and 2021. We study welfare implications of revenge consumption in a model of vertical product differentiation. We show that revenge consumption induces producing firms to enhance the quality levels and raise prices on their products. As the level of revenge consumption increases, social welfare initially increases but it eventually declines. Results, which hold across monopoly, duopolistic competition, and national brand-private label competition models, provide useful information for public policy.

Strategic outsourcing and quality choice: Is a vertical integration model sustainable?

This paper uses two versions of a vertical product differentiation model with price competition to investigate how strategic behavior between rival firms influences which organizational production mode each firm adopts: that is, either vertical integration or outsourcing. We show that not only a symmetric configuration, where both high‐ and low‐quality firms outsource, but also an asymmetric configuration, where the high‐quality firm produces in‐house whereas the low‐quality firm outsources, are acceptable as a subgame‐perfect equilibrium outcome. We explore the implications of these results in light of the recent slump in business of Japanese electronics enterprises in the flat‐panel television industry.

Dumping, Antidumping Duties, and Price Undertakings: Policy Implications of Trade in Quality-Differentiated Products

This paper examines which types of firms, from a developed country (DC) or a less developed country (LDC), tend to practice dumping, using a two-market equilibrium analysis of trade in like products. Specifically, we present a vertical product differentiation model of duopolistic competition between a DC firm and an LDC firm under free trade to show that the DC firm sells a higher-quality product without dumping. In contrast, the LDC firm sells a lower-quality product and practices dumping in the DC market by charging a price lower than the product's price in its LDC market. As such, dumping is a signal of lower product quality. The imposition of an antidumping duty by the DC government increases domestic welfare. The LDC's social welfare may increase if its exporting firm accepts a price-undertaking rather than dumping. From the perspective of world welfare, defined by aggregating the welfare of the trading countries (DC and LDC), the trade damage measure of imposing antidumping fines on LDC dumping is Pareto-improving compared to free trade (under which dumping takes place) and price-undertakings.

Preventing commercial piracy when consumers are loss averse

I analyze how the loss aversion of consumers affects the strategies of the government and the incumbent for preventing commercial piracy. To that end, I develop a sequential duopoly model of vertical product differentiation with price competition in which consumers have a reference-dependent utility. Regardless of the quality of the illegal copy, conventional models that do not take into account the loss aversion of consumers overestimate the government’s effort to deter piracy but underestimate the incumbent’s effort. Contrary to conventional wisdom, I find that blocking the entry of a pirate by the government can provide more welfare than accommodating it. However, the government will not block it because socially it is better to encourage the incumbent to establish a price low enough to deter the pirate from entering.

The Market for "Harmful Component-Free" Products Under Pressure from the NGOs

Non-governmental organizations (NGOs) are exerting growing pressure on firms to eliminate product components (such as palm oil) that are harmful to the environment (such as rainforests) or replace such components with NGO-certified sustainable components. Under which conditions does NGO pressure lead firms to eliminate basic components from their products or, alternatively, substitute damaging components with certified sustainable components? What are the ensuing effects on market structure, environmental quality, and social welfare? The paper addresses these issues using a model of two-dimensional vertical product differentiation. It shows that, for an NGO that collects certification fees to accrue its budget and finance its awareness campaign, it may — paradoxically — be optimal to reduce the certified product’s market share and eventually evict it.

Minimum quality standard regulation and entrepreneurial innovation

PurposeThe purpose of this paper is to explore the impact that minimum quality standards have on product quality when entrepreneurial innovation is considered.Design/methodology/approachThe author develops a game-theoretic model. It is a standard vertical product differentiation model, but incorporates a minimum quality standard and uncertain entrepreneurial innovation.FindingsWhile the minimum quality standard increases the expected quality of the low-quality product, under reasonable circumstances the expected quality of the high-quality good decreases. Thus, average quality can decrease with regulation intended to increase product quality.Research limitations/implicationsPast research on minimum quality standards does not consider its impact on entrepreneurial effort when their innovation investments lead to uncertain outcomes.Practical implicationsMinimum quality standard regulation can have counterproductive impacts if the impact on entrepreneurs is not considered. The regulation can disincentivize entrepreneurs leading to lower quality products.Social implicationsRegulation can be welfare reducing.Originality/valueThis paper is the first to incorporate entrepreneurial innovation into a product quality model to explore the impact of minimum quality standard regulation.

International Trade and Firm's Technological Choice

This paper analyzes the impact of international trade on a firm’s technological choice. Specifically, we examine how income and technological levels of export destination countries affect exporting firms’ relative incentives between product innovation and process innovation. Based on an illustrative model of vertical product differentiation, this paper suggests that bilateral trade between countries of different income levels tends to weaken the incentive for product innovation for both countries, relative to the autarky case. In addition, other things being equal, trade with countries whose income levels are relatively higher further reduces exporters’ incentive for product innovation, unless technology gap between trade partners is sufficiently large. Using the firm-level data for Korean manufacturing for the period of 2005-07, we find that there exists an inverted U-shaped relationship between trading partner’s income level and the R&D expenditure share on new product innovation. Our estimation results indicate that the relative incentive to invest in new product innovation tends to increase until the income level of the major trading partner reaches at 5,260 US dollars, then it decreases afterward.

The Low‐Quality Advantage in Vertical Product Differentiation

By assuming a triangular distribution of consumers' willingness to pay for quality, this paper makes use of the stylized fact that low‐income households are more numerous than high‐income households, and thus, income distributions are right‐skewed. Accordingly, we present a straightforward two‐firm, two‐stage vertical product differentiation model with quality‐dependent marginal production costs, where the firm offering the low‐quality product has the larger market share and profit than the top‐quality competitor. This can be termed low‐quality advantage and may explain the success of large retailers serving the masses by offering low‐quality products. Copyright © 2016 John Wiley & Sons, Ltd.

Input Prices and Product Differentiation

Abstract In this paper, we study how input prices affect product differentiation in network industries. In particular, we study whether the principle of vertical differentiation (Choi and Shin 1992, “A Comment on a Model of Vertical Product Differentiation.” The Journal of Industrial Economics 40 (2):229–31; Wauthy 1996, “Quality Choice in Models of Vertical Differentiation.” The Journal of Industrial Economics 44 (3):345–53) remains valid when an entrant purchases an essential input from an incumbent at a regulated price. We find that the higher quality firm always chooses the best available quality, whereas the lower quality firm chooses an intermediate quality, which increases with the input price. If the higher quality firm is the incumbent, a cost-oriented input price maximizes welfare, but comes at the cost of a lower average quality, a higher degree of product differentiation, and therefore stronger downstream market power.

Optimal Licensing Policy under Vertical Product Differentiation

AbstractThis paper explores a vertical product differentiation model with a licensing arrangement between a multinational firm with superior technology and a domestic firm with obsolete technology. We find that a subsidy provided by the domestic country's government to the domestic firm to assist with the licensing arrangement is welfare enhancing for the domestic country. Furthermore, both the multinational firm and the domestic country are better off under royalty than under fixed fee licensing. These findings stand in contrast to earlier results in the literature.

Credence Goods, Misleading Labels, and Quality Differentiation

Due to differences in information disclosure mechanisms, consumer misinformation about the quality of many credence goods is more endemic at intermediate levels of the quality spectrum rather than at the extremes. Using an oligopoly model of vertical product differentiation, we examine how consumers’ overestimation of the quality of intermediate-quality products affects firms’ incentives to improve product quality. The firms non-cooperatively choose the quality of their product before choosing its price or quantity. Irrespective of the nature of second stage competition, Bertrand or Cournot, we find that quality overestimation by consumers increases profit of the intermediate-quality firm, and motivates it to raise its product’s quality. In response, the high-quality firm improves its product quality even further but ends up with lower profit. Overall, average quality of the vertically differentiated product improves, which raises consumer surplus. Social welfare increases when the firms compete in prices but falls when they compete in quantities.