Vertical Differentiation Model Research Articles

Reference pricing, competition, and pharmaceutical expenditures: Theory and evidence from a natural experiment

We study the impact of regulation on competition between brand-names and generics and pharmaceutical expenditures using a unique policy experiment in Norway, where reference pricing (RP) replaced price cap regulation in 2003 for a sub-sample of off-patent products. First, we construct a vertical differentiation model to analyze the impact of regulation on prices and market shares of brand-names and generics. Then, we exploit a detailed panel data set at product level covering several off-patent molecules before and after the policy reform. Off-patent drugs not subject to RP serve as our control group. We find that RP significantly reduces both brand-name and generic prices, and results in significantly lower brand-name market shares. Finally, we show that RP has a strong negative effect on average molecule prices, suggesting significant cost-savings, and that patients' copayments decrease despite the extra surcharges under RP.

On production costs in vertical differentiation models

We analyze the effects of the introduction of a unit production cost in a vertical differentiation model with fixed costs of quality improvement: For a low (high) unit cost, a rise in cost reduces (increases) product differentiation and prices.

Avoiding commercial piracy

In this paper we analyse the roles of the government and an incumbent in preventing the entry of a pirate, who tries to avoid being caught. The framework of analysis used is a sequential duopoly model of vertical product differentiation with price competition. We find that both the government and the incumbent have key roles in preventing the entry of pirates. We show that the government will not help the incumbent to become a pure monopolist, even if it installs an antipiracy system. It will let the pirate enter either as a follower or a leader, or encourage the incumbent to set a low enough price to successfully deter the pirate from entering the market, depending on its technology for monitoring commercial piracy. Finally, we find that the pirate decides to become a leader to avoid being caught by the incumbent and the government.

Non-Cost-Raising Discrimination: A Rationale for Functional Separation in Broadband Open Access

I present a vertical differentiation model to assess the quality-wise strategy of an incumbent telecommunications operator under open access regimes. I show that it is always profitable for an incumbent subject to wholesale regulation to degrade wholesale quality in a non-recoverable fashion. The findings are robust to the number of competitors and the price cap level, unlike those predicted by the cost-raising discrimination paradigm. I also show that functional separation, a structural remedy aimed to separate the incumbent's wholesale and retail operations, better aligns supply-side incentives with those of consumers. The analysis suggests that structural remedies exhibit good properties to implement open access regimes.

Fighting strategies in a market with counterfeits

Counterfeiting is a widely spread phenomenon and has seen rapid growth in recent years. In this paper, we adopt the standard vertical differentiation model and allow consumers the choices of purchasing an authentic product, purchasing a counterfeit, or not buying. We focus on how non-deceptive counterfeits, which consumers know at time of purchase that the products are counterfeits with certainty, affect the price, market share and profitability of brand name products. We also consider the strategies for brand name companies to fight counterfeiting. We compare different fighting strategies in a market with one brand name product and its counterfeit, and derive equilibrium fighting strategies in a market with two competing brand name products and a counterfeit under general conditions.

Public Goods and Tax Competition in a Two‐Sided Market

AbstractA rather neglected issue in the tax competition literature is the dependence of equilibrium outcomes on the presence of firms and shoppers (two‐sided markets). Making use of a model of vertical and horizontal differentiation, within which jurisdictions compete by providing public goods and levying taxes in order to attract firms and shoppers, this paper characterizes the noncooperative equilibrium. It also evaluates the welfare implications for the jurisdictions of a popular policy of tax coordination: The imposition of a minimum tax. It is shown that the interaction of the two markets affects the intensity of tax competition and the degree of optimal vertical differentiation chosen by the competing jurisdictions. Though the noncooperative equilibrium is, as it is typically the case, inefficient such inefficiency is mitigated by the strength of the interaction in the two markets. A minimum tax policy is shown to be effective when the strength of the interaction is weak and ineffective when it is strong.

Pre-emption, Predation, and Minimum Quality Standards

We present a model of vertical product differentiation and exit where a domestic and a foreign firm face fixed setup costs and quality-dependent costs of production and compete in quality and price in the domestic market. Quality-dependent costs are quadratic in qualities, but independent of the quantities produced. The domestic government may impose a minimum quality standard binding for both foreign and domestic firms. In the presence of an initial cost advantage of the domestic firm, a sufficiently high minimum quality standard set by the domestic government will enable the domestic firm to induce exit of the foreign firm, i.e. to engage in predation. However, the same standard would lead to predation by the foreign firm, if the foreign firm had the initial cost advantage!

Entry deterrence and mergers under price competition in pharmaceutical markets

After patent expirations in pharmaceutical markets, brand-name laboratories are threatened by generic firms’ entry. To fill the gap in the theoretical literature on this topic, we study brand-name firms’ incentives either to deter entry, or to merge with the entrant. These strategies are considered along with the possibility of the brand-name firm producing its own generic drug, called a pseudo-generic drug. Using a vertical differentiation model with Bertrand–Stackelberg competition, we show that each strategy, merging and deterring entry, may be Nash equilibrium, according to the generic firm's setup cost level and to the rate of discount.

Minimum Quality Standard Regulation Under Imperfect Quality Observability

Minimum quality standards (MQS) constitute an important regulatory tool that can be used to raise product qualities, to benefit consumers and to increase market participation. One of the main assumptions in the existing literature is that firms must comply with standards. Nevertheless, in many industries, and in particular the service industry, quality observability and enforceability are not perfect. Some low quality firms do not comply with standards. What are the welfare implications of an MQS regulation in such an environment? We develop a price competition model of vertical differentiation that accounts for these empirical observations. Contrary to well-established results in the literature, MQS can increase quality disparity between firms and raise hedonic prices. Some consumers get hurt and market participation decreases.

EXPORT SUBSIDIES, COST DIFFERENTIAL AND PRODUCT QUALITY

This paper presents a vertical product differentiation model to examine the relationship between optimal trade policies and product qualities for different export countries under Cournot quantity competition as well as Bertrand price competition. We can also use this quality model to explain why Japan as a high production-cost country may have incentives to offer high subsidies. This is a case that cannot be explained by the strategic trade theory models à la Brander and Spencer (1985) or Eaton and Grossman (1986).

Reference Pricing, Competition, and Pharmaceutical Expenditures: Theory and Evidence from a Natural Experiment

We study the impact of regulation on competition between brand-names and generics and pharmaceutical expenditures using a unique policy experiment in Norway, where reference pricing (RP) replaced price cap regulation in 2003 for a sub-sample of off-patent products. First, we construct a vertical differentiation model to analyze the impact of regulation on prices and market shares of brand-names and generics. Then, we exploit a detailed panel data set at product level covering several off-patent molecules before and after the policy reform. Off-patent drugs not subject to RP serve as our control group. We find that RP significantly reduces both brand-name and generic prices, and results in significantly lower brand-name market shares. Finally, we show that RP has a strong negative effect on average molecule prices, suggesting significant cost-savings, and that patients’ copayments decrease despite the extra surcharges under RP.

The technology gap and the limit of imitation: An inspection of the strategy of ‘exchanging market for technology’

Has China's strategy of ‘exchanging market for technology’ been successful? This paper analyses the effectiveness of this strategy based on the duopoly model of vertical product differentiation by Choi and Shin (1992). It is shown that the outcome is influenced by technology gap and absorptive capacity. The profit of a developing country firm shows an inverted U-shaped relationship with its technology level when holding the foreign firm's technology level constant. In the process of technology improvement by imitation, the developing country firm faces a limit on imitation. A developing country may benefit from the strategy of ‘exchanging market for technology’ at the early stage and needs to bring in FDI with advanced technology so that it can overcome restraints from the limit of imitation. For one with a smaller technology gap with the home country of FDI, the country in the long run has to achieve technological progress through innovation.

Too much R&D? – vertical differentiation and monopolistic competition

Purpose – This paper aims to discuss whether product research and development (R&D) in developed economies tends to be too high compared with the socially desired level.Design/methodology/approach – In this context, a model of vertical and horizontal product differentiation within the Dixit‐Stiglitz framework of monopolistic competition is set up. Firms compete in horizontal attributes of their products, and also in quality that can be controlled by R&D investments.Findings – The paper reveals that in monopolistic‐competitive industries, R&D intensity is positively correlated with market concentration. Furthermore, welfare and policy analysis demonstrate an overinvestment in R&D with the result that vertical differentiation is too high and horizontal differentiation is too low. The only effective policy instrument in order to contain welfare losses is a price control of R&D services.Originality/value – Considering the extent of product R&D as well as the political efforts to promote public and private res...

Competitive Interactions in the IT Industry: World Practice and Russia

The article analyzes a model of vertical product differentiation applied to IT area which demonstrates that IT market is a natural oligopoly, the number of applications, the degree of compatibility in basic IT product modifications, the level of network effect being the main criteria of vertical product differentiation. Characteristics of IT products and types of competition in IT sphere are analyzed as well as the situation on the Russian IT market.

Successive duopoly under moral hazard: Will incentive contracts persist?

The central purpose of this paper is to examine the incentive contract as an equilibrium phenomenon. We analyse a model of vertical differentiation in which we deal with the strategic role of the competitor’s decisions in a successive duopoly. Is it better for a processor to offer an incentive contract to an upstream producer or the spot market? We determine the equilibrium of a game in which the processors simultaneously decide whether to offer an incentive contract or to continue at the spot market to acquire their input. Our results show that under successive duopoly, offering an incentive contract constitutes the unique equilibrium solution, which highlights the incentive contract persistence.

La tarification au prix de référence : quel impact sur le marché pharmaceutique ?

Dans le but de faire face à la hausse des dépenses de médicaments qui ont de lourdes conséquences sur l’équilibre budgétaire des organismes de protection sociale, de nouveaux systèmes de régulation du marché pharmaceutique, comme le prix de référence, ont été mis en place. Ce mécanisme établit un niveau maximum de remboursement pour un groupe de médicaments. En utilisant un modèle de différenciation verticale nous montrons que la mise en place d’une telle politique permet effectivement de réduire le prix des médicaments. Toutefois, l’impact concernant les dépenses publiques de médicaments reste difficile à établir.

On the Effects of Selective Below-Cost Pricing in a Vertical Differentiation Model

Abstract We analyse the effects of predation in a vertical differentiation model, where the high-quality incumbent is able to price discriminate while the low-quality entrant sets a uniform price. The incumbent may act as a predator, that is, it may price below its marginal costs on a subset of consumers to induce the rival’s exit. We show that the entrant may adopt an aggressive attitude to make predation unprofitable for the incumbent. In this case predation does not occur and the equilibrium prices are lower than the equilibrium prices which would emerge in a contest of explicitly forbidden predation. Moreover, we show that when the incumbent may choose whether to price discriminate or not before the game starts, if the quality cost function is sufficiently convex, there always exists a parameter space on which the incumbent prefers to commit not to price discriminate.

Successive duopoly under moral hazard: Will incentive contracts persist?

The central purpose of this paper is to examine the incentive contract as an equilibrium phenomenon. We analyse a model of vertical differentiation in which we deal with the strategic role of the competitor’s decisions in a successive duopoly. Is it better for a processor to offer an incentive contract to an upstream producer or the spot market? We determine the equilibrium of a game in which the processors simultaneously decide whether to offer an incentive contract or to continue at the spot market to acquire their input. Our results show that under successive duopoly, offering an incentive contract constitutes the unique equilibrium solution, which highlights the incentive contract persistence.

Vertical Differentiation, Social Networks and Compatibility Decisions

This paper considers a vertical differentiation model with positive network effects. It is based on the assumption that consumers belong to the same network if they buy products exhibiting close characteristics. Thus, the network has two characteristics: its intensity and its selectivity. The higher the network intensity, the more positively affected the consumer is by the network size. The network selectivity corresponds to how close the products' characteristics should be to be perceived by consumers as compatible. The closer two compatible products are in the product space, the more selective the network.We analyze the strategic behavior in terms of prices and qualities of two firms: an incumbent and a potential entrant. By choosing its quality the entrant chooses at the same time to be compatible or not.We show that if the network intensity is moderate, it is always profitable for the entrant to enter the market. In this case the entrant is compatible with the incumbent when the network is not very selective and is incompatible when the network is selective. If the network intensity is strong, we prove that it acts as a barrier to entry under incompatibility. The equilibrium outcomes in this case are either no entry or compatible.

Interfirm and Intrafirm Switching Costs in a Vertical Differentiation Setting: Green versus Nongreen Products

In a vertical differentiation model where both duopolists supply the same two qualities of an otherwise homogeneous product, we derive the critical level of the interfirm switching cost needed to sustain monopoly pricing. In particular, we show how a decrease in the intrafirm switching cost may cause a decrease in this critical value, thereby facilitating monopoly pricing. We apply the results to a setting with green and nongreen products—in particular electricity—and discuss implications for policy measures intended to stimulate the production and consumption of green products.