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Communicated by G. Leitmann
1. Introduction
2. Model
Πi (t)G 冮0
π i (t) e −pt dt, (12)
w.r.t. the controls qi (t) and ai (t), under the constraint given by the state
dynamics (11).
For future reference, we define also the consumer surplus,
CS(t)GCSL (t)CCSH (t), (13)
where
θ̂ (t)
3. Duopoly Equilibrium
6
Second-order conditions are always met throughout the paper. They are omitted for brevity.
266 JOTA: VOL. 119, NO. 2, NOVEMBER 2003
The above FOCs entail that the present game is a linear state game, produc-
ing subgame perfect or Markov perfect open-loop Nash equilibria.7 Notice
also that conditions (18)–(19) do not contain λ ij because the present game
features separated dynamics.8 Therefore, the problem admits the solution
λ ij G0 for all t∈[0,S) and j ≠ i. Accordingly, we specify only one costate
equation per firm,
which can be plugged into the system of state equations (11), simplifying as
follows:
7
See e.g. Refs. 23–24. For an exhaustive exposition of linear state games, see Ref. 4 (Chapter 7).
8
This also entails that rewriting the model over a finite-time horizon with an appropriate scrap
value, this problem could be solved also with the alternative coordinate transformation method
of Ref. 25.
JOTA: VOL. 119, NO. 2, NOVEMBER 2003 267
The above output levels are acceptable if and only if they are nonnega-
tive. Of course, this depends upon the relative size of the demand and cost
parameters {s, θ 1 , bi , ci }. First, note that the denominator of xSS
i is positive
for all admissible values of parameters. Since we are treating the issue of
enlarging market shares through advertising, it is interesting to examine the
nonnegativity of the outputs in terms of the parameters bi and their interac-
tion with production cost parameters ci. We can prove the following lemma.
Lemma 3.2. If
cH ∈(cL s兾2(1C2cL θ 1 s), cL),
then xSS
L H0 for all bH H0. If instead,
scLA2cH (1C2cL θ 1 s)
bH Hb̄H ≡ „0.
2δ cH ( ρCδ )(1C4θ 1 cL s)
L G0 for all bH ∈[0, b̄H ].
Otherwise, xSS
scLA2cH (1C2cL θ 1 s)
bH Hb̄H ≡ .
2δ cH ( ρCδ )(1C4θ 1 cL s)
This is surely true for all admissible bH if
cH ∈(cL s兾2(1C2cL θ 1 s), cL),
since this implies b̄H F0. In the case where
cH ∈(0, cL s兾2(1C2cL θ 1 s)],
then b̄H „0. Therefore, in this range of cH, we have that xSS
L „0 iff
bH „b̄H . This concludes the proof. 䊐
Now, on the basis of Lemma 3.2, one can also check that, in equilib-
L ≡ θ̂ (t)Aθ̃ (t) ensures also that θ̂ (t)„ θ̃ (t).
rium, the nonnegativity of xSS
Lemmas 3.1 and 3.2 imply directly a relevant corollary.
Lemma 3.4. If b̂H H0, then xSS H HxL for all bH ∈(0, b̂H); xH FxL for
SS SS SS
SS SS
all bH Hb̂H . If instead b̂H ‚0, then xL HxH .
The foregoing discussion (in particular, Corollary 3.1 and Lemma 3.4)
opens the possibility that there exist admissible parameter constellations
such that both firms enjoy positive market shares and profits in equilibrium,
with the low-quality firm serving more consumers and earning higher profits
than the high-quality firm.
9
As we already know, for all s∈(0, 1), the denominator of xiSS is always positive. Therefore,
SS
the value of bH such that xH AxLSS G0 is unique and it is given by b̂H .
270 JOTA: VOL. 119, NO. 2, NOVEMBER 2003
Not surprisingly,
i 兾∂θ 1 H0.
∂xSS
That is, as the market becomes more affluent, demand for all varieties
increases.
Now consider the effects of a change in the efficiency of the advertising
investments on market shares. First of all, notice that
H 兾∂bH F0,
∂xSS ∂xSS
L 兾∂bH H0, (32)
in the whole admissible parameter range. This is what one would expect
from the outset: as the advertising campaign of firm H becomes less expen-
sive (or more effective), the demand for the high-quality good is enhanced
while that for the inferior variety shrinks.
The effect of a change in bL on xSSi is more involved,
H 兾∂bL H0 and ∂xL 兾∂bL F0,
∂xSS SS
for all cH Hc̃H , (33)
scL
c̃H G (34)
2[1C2cL θ 1 sCbH δ (1C4cL θ 1 s)(δCρ)]
and conversely for all cH ∈(0, c̃H ]. This means that, when vertical product
differentiation is relatively low (which holds when cH Hc̃H ), any increase in
bL drives some consumers to switch from the inferior variety to the high-
quality good. This does not happen if the degree of differentiation is large
enough.
We are now in a position to assess the firms relative performance in
terms of steady-state profits,
[1CbH δ (δC2ρ)]Ω2
π SS
H G , (35)
16c2H c2L [4bL δ (δCρ)[1CbH δ (δCρ)]C[4C4bH δ (δCρ)As]s]2
Ω ≡ cH [1C4cL θ 1 (−2Cs)]sA2bL cL δ (1C4cH θ 1)(δCρ)A2cL , (36)
[bL δ (δC2ρ)Cs]Ψ2
π SS
L G , (37)
16c2H c2L [4bL δ (δCρ)[1CbH δ (δCρ)]C[4C4bH δ (δCρ)As]s]2
Ψ ≡ cL sA2cH [1C2cL θ 1 sCbH δ (δCρ)(1C4cL θ 1 s)]. (38)
JOTA: VOL. 119, NO. 2, NOVEMBER 2003 271
Lemma 3.5. If b̃H H0, then π SS H Hπ L for all bH ∈(0, b̃H); π H Fπ L for
SS SS SS
Lemmas 3.4 to 3.6 yield a partition of the parameter space into three
regions, according to the value assumed by the advertising efficiency param-
eter of high-quality firm, bH. This partition is illustrated in Fig. 1, assuming
that the parameter set is such that
b̃H Hb̂H H0Hmax{b¡ H , b̄H }.
This means that we exclude the trivial case where the market is a monopoly
for firm H.
Proposition 3.2. Take values of {s, θ 1 , ci } such that b̃H Hb̂H H0. If
H HxL , aH HaL , and π H Hπ L . If bH ∈(b̂H , b̃H), then
bH ∈(0, b̂H), then xSS SS SS SS SS SS
and π H Fπ L .
SS SS
10
The equation π H
SS
Gπ LSS yields two roots. While the smaller is always negative, the larger may
or may not be positive. The expressions are omitted for brevity.
11
One such numerical example is in the Appendix (Section 6).
272 JOTA: VOL. 119, NO. 2, NOVEMBER 2003
consider that the critical levels b̃H and b̂H are a function of bL. Then, exam-
ine the case bH ∈(0, b̂H). Here, the advertising technology of firm H is suffic-
iently efficient, as compared to that of firm L, to imply that firm H acquires
a dominant position in the market. If instead bH ∈(b̂H , b̃H), the relative
decrease in the efficiency of its advertising campaign induces firm H to invest
less in advertising, which in turn entails that its equilibrium demand
becomes lower than that of firm L. However, this is not yet sufficient to
reverse the inequality on profits because the reduction in the market share
is still more than offset by the quality differential. In the third range, where
bH Hb̃H , the distribution of consumers between firms induces a reversal of
the profit ranking. All this amounts to saying that having a larger market
share in equilibrium is not sufficient to earn higher profits than the rival.
Observe that, in line of principle, b̂H Hb̃H is admissible. However, this
case would not allow for a sensible interpretation in terms of the underlying
economics. In particular, if that were indeed the case, one would observe a
nonmonotone behavior of the relative profits of firms. In particular, as the
advertising technology of firm H becomes less efficient, we would obtain
that initially π SSH Hπ L , then π H Fπ L
SS SS SS
for bH ∈(b̃H , b̂H), then again
π H Hπ L for bH Hb̂H . For this reason, we can dismiss such a case.
SS SS
Proposition 4.1. Under both monopoly and social planning, the opti-
mal qualities are the same as under the profit-seeking duopoly (D):
JOTA: VOL. 119, NO. 2, NOVEMBER 2003 273
∂H k兾∂qi G∂H D
i 兾∂qi G∂π i 兾∂qi G0,
since the consumer surplus is independent of quality levels. 䊐
Another obvious result needs no proof. This regards the profit perform-
ance of the industry in the three regimes at stake. Clearly, the highest attain-
able profits in equilibrium accrue to the monopolist selling both varieties,
that, by definition, must perform better than the sum of two independent
single-good duopolists. Then, it is also straightforward that the profit-seek-
ing duopolists earn strictly larger profits than a social planner taking care
of consumer surplus into his objective function.
Concerning the performance of the monopolist selling both varieties,
we can prove the following proposition.
1C4cH (θ 1A2xHA2sxL)
aM
HG ,
8bH cH (δCρ)
1C4cL s(θ 1A2xHA2xL)
aM
L G ,
8bL cL (δCρ)
Fig. 2. Comparisons.
JOTA: VOL. 119, NO. 2, NOVEMBER 2003 275
5. Concluding Remarks
6. Appendix: Proofs
ai , that is, (23) or (24), alternatively. In the two cases, that can be treated
in isolation because of the separated dynamics assumed in the model, the
system can be written in matrix form as follows:
−δ
冤ȧ 冥 G 冤 2 冥冤 冥 冤 冥
ẋH 1 xH 0
C ,
H 2bH (δCρ) aH sxLA1兾(4cH)Aθ 1
−δ
冤ȧ 冥 G 冤 2s 冥 冤a 冥C 冤sx A1兾(4c )Asθ 冥 .
ẋL 1 xL 0
L 2bL (δCρ) L H L 1
Since the determinants of the above 2B2 matrices are both negative, the
equilibria that we have obtained are two saddles. From the phase diagram
(Fig. 3), it is clear that these can be approached only along the north-west
arm of the saddle path. 䊐
冤冥冤 冥冤 冥 冤 冥
ẋH 1 0 0 xH 0
ȧH 2 2bH (δCρ) 2s 0 aH −1兾4cHAθ 1
G C .
ẋL 0 0 −δ 1 xL 0
ȧL 2s 0 2s 2bL (δCρ) aL −1兾4cLAsθ 1
By computing the four eigenvalues, it is easy to assess that
λ 1 Gλ 3 H0 and λ 2 Gλ 4 F0.
Hence, the equilibrium is a saddle point. 䊐
∂H SP
兾∂xL G−δλ LLCqLAcL q2LCs (θ 1AxHAxL) (59)
Gρλ LLAλ̇ LL ,
with the same initial and transversality conditions as in the previous cases.
From (58) and (59), we have
λ̇ H G(δCρ)λ HAθ 1AqHCcH q2HCxHCsxL , (60)
λ̇ L G(δCρ)λ LAqLCcL q As(θ 1AxHAxL),
2
L (61)
while from (57),
ȧH Gλ̇ H 兾2bH G−1兾4cHAθ 1C2aH bH (δCρ)CxHCs xL , (62)
ȧL Gλ̇ L 兾2bL G−1兾4cLC2aL bL (δCρ)Cs (−θ 1CxHCxL). (63)
The steady-state equilibrium requirement {ȧH G0, ȧL G0} yields
1C4cH (θ 1AxHAsxL)
aSP
H G , (64a)
8bH cH (δCρ)
1C4cL s (θ 1AxHAxL)
aSP
L G , (64b)
8bL cL (δCρ)
JOTA: VOL. 119, NO. 2, NOVEMBER 2003 279
冤冥冤 冥冤 冥 冤 冥
ẋH 1 0 0 xH 0
ȧH 1 2bH (δCρ) s 0 aH −1兾4cHAθ 1
G C .
ẋL 0 0 −δ 1 xL 0
ȧL s 0 s 2bL (δCρ) aL −1兾4cLAsθ 1
Again, computing the four eigenvalues, one can check that
λ 1 Gλ 3 H0 and λ 2 Gλ 4 F0.
Therefore, the equilibrium is a saddle point. 䊐
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