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Product Differentiation1

L. COLOMBO2 AND L. LAMBERTINI3

Communicated by G. Leitmann

quality is endogenous. In the differential game between single-product

firms, there exists a parameter range where the low-quality firm uses a

more efficient advertising technology and earns higher profits than the

rival. Moreover, we show that equilibrium qualities are the same under

duopoly, multiproduct monopoly, and social planning, the only distor-

tion being concerned with the output levels.

control.

1. Introduction

in monopoly model or in oligopoly model; see Refs. 1–3 and Ref. 4 (Chap-

ter 11). To the best of our knowledge, the endogenous interplay between

advertising and product quality has not received a large amount of attention

so far. The few existing contributions in this field consider usually the opti-

mal control of advertising efforts and product quality in relation with build-

ing up the stock of goodwill, under incomplete consumer information.4 One

interesting exception dealing with a full information model of dynamic

advertising and product quality is in Ref. 8, extending the well-known

Lanchester model to account for the interplay between market shares and

quality.5 Others have investigated, adopting either static or dynamic

1

The authors thank Gustav Feichtinger for an insightful discussion that inspired this paper,

Roberto Cellini, and the seminar audience in Bologna for useful comments.

2

Research Fellow, Department of Economics, University of Bologna, Bologna, Italy.

3

Professor of Economics, Department of Economics, University of Bologna, Bologna, Italy.

4

See Refs. 5–7, Ref. 3, and the references therein.

5

For the formulation of the Lanchester model, see Ref. 2, Ref. 4 (Chapter 11), and Refs. 9–10.

261

0022-3239兾03兾1100-0261兾0 2003 Plenum Publishing Corporation

262 JOTA: VOL. 119, NO. 2, NOVEMBER 2003

to build up market shares (Refs. 11–13).

We study persuasive advertising in a dynamic market where fully

informed consumers may choose between two goods characterized by differ-

ent quality levels which are determined endogenously. We consider (i) the

differential game between two single-product firms, (ii) the optimal control

problem faced by a monopolist supplying both varieties so as to maximize

profits, and (iii) the optimal control problem solved by a benevolent planner

supplying both varieties so as to maximize social welfare.

Our main results can be summarized as follows. In the duopoly game,

there exist parameter ranges wherein the low-quality firm earns higher pro-

fits than the high-quality firm, due to the fact that the number of consumers

choosing the low-quality good is considerably larger than the number of

consumers buying the high-quality good. This is in contrast with the

acquired wisdom coming from the existing static games describing quality

competition in oligopoly (Refs. 14–18, inter alia), where the possible interac-

tion between quality and advertising is disregarded completely and the equi-

librium market share of the high-quality good is always larger than the that

of the low-quality good. While in the static literature on this issue it is

always true that supplying a superior quality enables the firm (i) to extract

a higher profit margin from each unit and (ii) to obtain a larger market

share than that of the rivals, here we show that being able to attract the

richest set of costumers is insufficient to ensure higher profits because

inferior qualities may serve larger market shares. This appears to be

realistic, e.g., if one considers that selling a luxury motorbike like the Ducati

999 may well entail a larger unit price-cost margin than selling a Honda

Hornet, but the number of customers that can afford a Hornet is surely

much larger than the number of customers who may afford a Ducati 999.

Moreover, in our model, the quality levels turn out to be independent

of the market regime; i.e., they are the same at the duopoly, monopoly, and

planning equilibria. Again, this finds no correspondence in the static litera-

ture on vertical product differentiation, where it emerges usually that the

degree of vertical differentiation at the duopoly equilibrium is larger than

the monopoly optimum and the social optimum, due to the incentive for

firms to increase product differentiation so as to soften price competition

(Refs. 16 and 19). In addition, our result also tells that there is no quality

distortion at the monopoly equilibrium, as compared to the first best. While

in static models we observe the incentive for the monopolist to undersupply

or oversupply product quality in order to induce self-discrimination across

consumers (Refs. 19–21), here we observe only a downward distortion in

output levels due to monopoly power.

JOTA: VOL. 119, NO. 2, NOVEMBER 2003 263

laid out in Section 2. The duopoly setting is investigated in Section 3, while

Section 4 contains the analysis of the monopoly and first best equilibria.

Concluding remarks are given in Section 5.

2. Model

postulate the existence of a consumers gross surplus function which is

assumed to be nonseparable in its arguments. Instead, we assume that all

the arguments of the utility function are separable additively. Consumers

are indexed by a marginal willingness to pay θ ∈[0, θ 1 ], with density equal

to one, so that the total mass of consumers is θ 1. The distribution of con-

sumers and the support are invariant w.r.t. time. The market exists for

t∈[0,S), with the time being considered as continuous. At each t, the mar-

ket is supplied by two single-product firms offering goods of quality qi (t),

with iG{H, L}, qH (t)„qL (t)„0, which are perfectly observable, together

with the price vector, by consumers before purchase. Production entails an

instantaneous variable cost of quality improvement, which is assumed to be

convex in the current quality level,

Ci (t)Gci xi (t)[qi (t)]2, (1)

with constant parameters 0FcH FcL indicating that the high quality firm is

more efficient in the production of quality.

From the consumption of the high quality good, a consumer of type θ

draws the following net surplus:

UH GθCqH (t)ApH (t), (2)

where pH (t) is the market price of variety H at time t. Similarly, from the

consumption of the low quality good, a consumer indexed by θ draws the

following net surplus:

UL GsθCqL (t)ApL (t), (3)

where pL (t) is the market price of variety L at time t and s∈(0, 1) is a

positive and time-invariant parameter capturing the idea that gross satisfac-

tion of such consumer from buying the low quality good is lower. If a

consumer does not buy either variety, the resulting utility is nil. In order to

obtain the expressions of market demands, we compute the threshold of θ

which characterizes the consumer who is indifferent between buying from

the high quality firm and buying from the low quality firm,

θ̂ (t)G[ pH (t)ApL (t)AqH (t)CqL (t)]兾(1As), (4)

264 JOTA: VOL. 119, NO. 2, NOVEMBER 2003

ferent between buying from the low quality firm and not buying at all,

θ̃ (t)G[ pL (t)AqL (t)]兾s. (5)

The direct demand system follows the relations

xH (t)Gθ 1Aθ̂ (t), (6)

xL (t)Gθ̂ (t)Aθ̃ (t), (7)

provided that θ̃ (t)H0, ensuring that we are in the nondegenerate case where

partial market coverage prevails. If so, we can write the inverse demand

system,

pH (t)Gθ 1CqH (t)AxH (t)AsxL (t), (8)

pL (t)GqL (t)Cs[θ 1AxH (t)AxL (t)]. (9)

Observe that the relations (4)–(9) define correctly the demand system if and

only if θ̂ (t)„ θ̃ (t), which amounts to requiring that

s[ pH (t)AqH (t)]„pL (t)AqL (t).

In the remainder of the paper, we will check that this condition indeed holds

at the duopoly steady-state equilibrium. The economic interpretation of this

requirement is that one should exclude the case of quality leapfrogging in

either direction, i.e., any situation such that the firm endowed with a techno-

logical efficiency parameter cH [respectively, cL] decides to produce a lower

[resp., higher] quality than the firm using the less [respectively, more]

efficient technology.

The instantaneous profits are written as follows:

π i (t)G[ pi (t)Aci [qi (t)]2]xi (t)Abi [ai (t)]2, (10)

2

where bi [ai (t)] is the instantaneous cost of investing in advertising, ai (t)

being the advertising effort of firm i at time t. We assume that the sales

evolve over time in response to the advertising investments, according to

the following kinematic equation (as in Ref. 22):

∂xi (t)兾∂t ≡ xi Gai (t)Aδ xi (t), iGH, L, (11)

where δ denotes the depreciation (disaffection) rate, constant over time and

common to both firms. It is worth stressing that this advertising technology

has asymmetric effects on the market demand of the two firms. The reason

is that the low-quality firm may increase demand by attracting consumers

in the lower part of the preference spectrum [i.e., pushing θ̃ (t) down] as well

as in the intermediate range of preferences [i.e., pushing θ̂ (t) up], while the

high-quality firm can fight only against the rival for θ̂ (t), since the upper

JOTA: VOL. 119, NO. 2, NOVEMBER 2003 265

for the low-quality firm to perform better than the high-quality firm in

equilibrium.

Firm i aims at maximizing the discounted profit flow,

S

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)

(szCqL (t)ApL (t)) dz

θ1

(zCqH (t)ApH (t)) dz

If we disregard the issue of surplus distribution between consumers and

producers, and we confine our attention to Pareto efficiency, we can define

welfare as follows:

W(t)GCSH (t)CCSL (t)Cπ H (t)Cπ L (t). (16)

3. Duopoly Equilibrium

The first-order conditions (FOCs) on the controls are (henceforth, we omit

the indication of time for brevity)6

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,

Gρλ HHAλ̇ HH , (20)

Gρλ LLAλ̇ LL , (21)

t→S

Now, using (19) and the costate equations, we write

ȧL Gλ̇ LL 兾2bL G−1兾4cLC2aL bL (δCρ)Cs(−θ 1CxHC2xL). (24)

aL G[1C4cL s (θ 1AxHA2xL)]兾8bL cL (δCρ), (26)

which can be plugged into the system of state equations (11), simplifying as

follows:

ẋL G[1C4cL s(θ 1AxHA2xL)]兾8bL cL (δCρ)Aδ xL . (28)

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

quadrant of the space {xi , ai }, which is described in Fig. 1. The system

{ẋi G0, ȧi G0} yields the following steady-state sales:

2bL cL δ (1C4cH θ 1)(δCρ)As{−2cLCcH [1C4cL θ 1 (sA2)]}

xSS

H G , (29)

4cH cL (4bL δ (δCρ){1CbH δ (δCρ)C[4C4bH δ (δCρ)As]s}

−cL sC2cH [1C2cL θ 1 sCbH δ (δCρ)(1C4cL θ 1 s)]

xSS

L G . (30)

4cH cL (4bL δ (δCρ){1CbH δ (δCρ)C[4C4bH δ (δCρ)As]s}

These expressions can be plugged into (25)–(26) to yield the optimal invest-

ments in advertising, aSS

i . The following proposition holds.

i , xi } is a saddle

point.

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.

H is

always positive.

2bL cL δ (1C4cH θ 1)(δCρ),

268 JOTA: VOL. 119, NO. 2, NOVEMBER 2003

−s{−2cLCcH [1C4cL θ 1 (sA2)]}H0

as well. To see this, rewrite it as

s[2cLAcHC4cH cL θ 1 (2As)],

which is positive for all s∈(0, 1) and cH FcL . 䊐

Lemma 3.2. If

cH ∈(cL s兾2(1C2cL θ 1 s), cL),

then xSS

L H0 for all bH H0. If instead,

SS

then x H0 for all

L

scLA2cH (1C2cL θ 1 s)

bH Hb̄H ≡ „0.

2δ cH ( ρCδ )(1C4θ 1 cL s)

L G0 for all bH ∈[0, b̄H ].

Otherwise, xSS

L H0 for all

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.

is monopolist for all bH ∈[0, b̄H ].

JOTA: VOL. 119, NO. 2, NOVEMBER 2003 269

(or conversely, the cost of advertising is sufficiently low), there is no room

in the market for the inferior variety.

For (29)–(30) to be acceptable, it must be also that

θ 1 HxSS SS

H CxL ;

H CxL for all bHHmax{b

¡ H , 0}, where

cL [sC2bL δ (δCρ)]CcH [2A8bL cL δθ 1 (δCρ)As(1C4cL θ 1)]

b¡ H ≡ ,

2cH δ (δCρ){4cL θ 1 [2bL δ (δCρ)Cs]A1}

with ∂b¡ H 兾∂bL F0 always.

∂b¡ H cL [1C4cH θ 1 (1As)]

G− F0. 䊐

∂bL cH {4cL θ 1 [2bL δ (δCρ)Cs]A1}2

easier to obtain in equilibrium, the higher the level of both the advertising

cost parameters. Now define

2bL cL δ (δ + ρ)+3cL sAcH {2+s+4cL θ 1 [−2bL δ (δ + ρ)+(−1+s)s]}

b̂H ≡ (31)

2cH δ (δ + ρ)(1+4cL θ 1 s)

as the level of bH such that xSS SS SS SS

H GxL . Assessing xH AxL , one can prove

9

easily the following lemma.

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

i 兾∂c j H0, i ≠ j, can be inter-

sales w.r.t. all parameters. First, the property ∂xSS

preted easily. All else being equal, as firm j becomes less efficient in supply-

ing quality (i.e., qj decreases as cj increases), the product of firm j becomes

less appealing and some customers switch to firm i. With regard to an

increase in the own cost of quality improvement, we have the expected

property

∂xSS

i 兾∂ci F0.

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

H and π L , we obtain a

SS

SS SS

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

SS SS

b̂HAb̄H T2bL cL δ (1C4cH θ 1)(δCρ)As{−2cLCcH [1C4cL θ 1 (sA2)]}

with the expression of the r.h.s. coinciding with the numerator of (29), that

is always positive as we already know from Lemma 3.1.11 䊐

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

SS SS SS SS SS SS SS SS

H FxL , aH FaL

SS

and π H Fπ L .

SS SS

values are such that there exists an admissible range wherein both firms are

active and earn positive profits in steady state. Moreover, in contrast with

the conclusions commonly drawn from the static approach to vertical differ-

entiation in oligopoly, in one subset of the parameters the low-quality firm

performs better than the high-quality firm in terms of both market share

and equilibrium profits. This fact can be interpreted as follows. First of all,

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

respectively, by (i) a profit-seeking monopolist and by (ii) a benevolent plan-

ner maximizing social welfare. In the monopoly regime (M), the current

value Hamiltonian function turns out to be

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

property structure of the two plants (i.e., of the regime k), the first-order

condition on the Hamiltonian w.r.t. quality qi is

∂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.

generic output levels are

1C4cH (θ 1A2xHA2sxL)

aM

HG ,

8bH cH (δCρ)

1C4cL s(θ 1A2xHA2xL)

aM

L G ,

8bL cL (δCρ)

xM

HG ,

8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s}

−cL sCcH (1CbH δ (δCρ)(1C4cL θ 1 s))

xM

L G .

8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s}

274 JOTA: VOL. 119, NO. 2, NOVEMBER 2003

for generic output levels are

1C4cH (θ 1AxHAsxL)

aSP

H G ,

8bH cH (δCρ)

1C4cL s(θ 1AxHAxL)

aSP

L G ,

8bL cL (δCρ)

while the steady-state output levels are

2bL cL δ (1C4cH θ 1)(δCρ)Cs[cLCcH (−1C4cL θ 1A4cL sθ 1)]

xSP

H G ,

4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s}

−cL sCcH [1C2bH δ (δCρ)(1C4cL θ 1 s)]

xSP

L G .

4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s}

The social optimum is a saddle point.

in advertising in the three regimes. The state dynamics (11) (the same across

regimes) and the dynamics of advertising efforts ai (changing across regimes)

are drawn in Fig. 2. Without further proof, the properties of this graph,

Fig. 2. Comparisons.

JOTA: VOL. 119, NO. 2, NOVEMBER 2003 275

the three regimes, produce the following proposition.

i implying

that xiSP HxD M

i Hxi .

surplus, and as qualities are the same across regimes, then clearly the social

incentive to invest in advertising is driven by the fact that increasing the

extent of market coverage amounts to increasing welfare. This explains also

that, in both profit-seeking regimes, which by definition do not take into

account the consumer surplus, the advertising expenditure must be lower

than the socially desirable investment. Moreover, if each variety is supplied

by an independent firm, it surely invests more to advertise its product than

a monopolist would do for the same variety. The reason is that a single-

product duopolist wants to steal costumers from the demand basin of the

rival, which of course cannot be the case for a multiproduct monopolist.

5. Concluding Remarks

invest both in product quality and advertising campaigns. We have assumed

that sales evolve over time in response of advertising investments, while

product quality improvements do not require any capital accumulation to

take place.

Contrary to the results we are familiar with from static analyses, we

have shown that there exists a range of parameters in which the low-quality

firm gains a higher market share as well as higher profits than the rival. The

reason behind this result lies in the relative efficiency of the advertising

technologies used by the two firms.

Moreover, we have shown that the level of product quality provided

by a duopoly corresponds to the one which is socially desirable. This is true

also under a monopolistic regime. The unique distortions which arise at

the privately optimal equilibria are on the output side. These downward

distortions due to market power are induced obviously by pricing above

marginal cost and therefore are qualitatively the same as in the static

literature.

6. Appendix: Proofs

(11) in combination with the appropriate kinematics of the control variable

276 JOTA: VOL. 119, NO. 2, NOVEMBER 2003

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

the parameters:

θ 1 G1, bL G1兾10, cH G7兾10, (41a)

cL G3兾4, sG9兾10, δ Gρ G1兾20. (41b)

If so, then

π SS

L Hπ H ,

SS

for all bH Hb̃H ⯝22.105.

JOTA: VOL. 119, NO. 2, NOVEMBER 2003 277

π SS

H ⯝0.2037, π SS

L ⯝0.2041, H ⯝0.4178,

xSS xSS

L G0.4760. (42)

Hamiltonian (39) are

∂H 兾∂qi G0 ⇒ xiA2ci qi xi G0 ⇒ qi G1兾2ci ,

M

(43)

M

(44)

M

(45)

M

(46)

along with the same initial and transversality conditions as in the duopoly.

From (45) and (46), we have

λ̇ H G(δCρ)λ HAθ 1AqHCcH q2HC2xHC2sxL , (47)

λ̇ L G(δCρ)λ LAqLCcL q As (θ 1A2xHA2xL),

2

L (48)

while from (44),

ȧH Gλ̇ H 兾2bH G−1兾4cHAθ 1C2aH bH (δCρ)C2xHC2sxL , (49)

ȧL Gλ̇ L 兾2bL G−1兾4cLC2aL bL (δCρ)Cs (−θ 1C2xHC2xL). (50)

The steady-state equilibrium requires {ȧH G0, ȧL G0}

1C4cH (θ 1A2xHA2sxL)

aM

HG , (51a)

8bH cH (δCρ)

1C4cL s(θ 1A2xHA2xL)

aM

L G . (51b)

8bL cL (δCρ)

Then, simplifying the state kinematics yields

1C4cH (θ 1A2xHA2sxL)

ẋH G , −dxH , (52)

8bH cH (δCρ)Aδ xH

1C4cL s(θ 1A2xHA2xL)

ẋL G , −dxL . (53)

8bL cL (δCρ)Aδ xL

At the resulting unique steady state, the sales are

bL cL δ (1C4cH θ 1)(δCρ)Cs[cLCcH (−1C4cL θ 1A4cL sθ 1)]

xSS

H G , (54)

8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s}

−cL sCcH [1CbH δ (δCρ)(1C4cL θ 1 s)]

xSS

L G . (55)

8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s}

278 JOTA: VOL. 119, NO. 2, NOVEMBER 2003

−δ

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

social planner Hamiltonian (40) are

SP

(56)

SP

(57)

SP

∂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

1C4cH (θ 1AxHAsxL)

ẋH G , −dxH , (65)

8bH cH (δCρ)Aδ xH

1C4cL s(θ 1AxHAxL)

ẋL G , −dxL . (66)

8bL cL (δCρ)Aδ xL

Solving the system {ẋH G0, ẋL G0}, one obtains the steady-state sales,

2bL cL δ (1C4cH θ 1)(δCρ)Cs[cLCcH (− 1C4cL θ 1A4cL sθ 1)]

xSS

H G , (67)

4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s}

−cL sCcH [1C2bH δ (δCρ)(1C4cL θ 1 s)]

xSS

L G . (68)

4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s}

Finally, the dynamic system can be written in the matrix form

−δ

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

References

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