Working Paper: CEPR ID: DP10027
Authors: Raphael Auer; Philip Saur
Abstract: We develop a model of vertical innovation in which firms incur a market entry cost and choose a unique level of quality. Once established, firms compete for market shares, selling to consumers with heterogeneous tastes for quality. The equilibrium of the pricing game exists and is unique within our setup. Exogenous productivity growth induces firms to enter the market sequentially at the top end of the quality spectrum. A central feature of the model is that optimization problems of consecutive entrants are self-similar so that new firms enter in constant time-intervals and choose qualities that are a constant fraction higher than incumbent qualities. The asymmetries of quality choice, which inevitably arise because the quality spectrum has top and a bottom, is thus overcome by sequential entry. Our main contribution lies in handling these asymmetries.
Keywords: Vertical differentiation; Product quality; Non-homogenous preferences; Natural monopoly; Endogenous growth; Quality ladders
JEL Codes: D4; D43; L11; L13; L15; O4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exogenous productivity growth (O49) | firms enter the market sequentially at the higher end of the quality spectrum (L15) |
| firms enter the market sequentially at the higher end of the quality spectrum (L15) | quality improvements (L15) |
| more firms enter (L19) | competition intensifies (L13) |
| competition intensifies (L13) | lower markups and prices for existing firms (L11) |
| increase in market size (F61) | more frequent entries (Y60) |
| decrease in entry costs (L11) | more frequent entries (Y60) |
| more frequent entries (Y60) | denser supply of qualities (L15) |