Advances in Vertical Differentiation: theory and applications
- Universidade de Aveiro(líder)
- Associação do Instituto Superior Técnico para a Investigação e o Desenvolvimento (Sigla: IST-ID)(parceiro)
- Universidade Católica Portuguesa(parceiro)
- Universidade de Évora(parceiro)
- Universidade do Algarve(parceiro)
Summary
The aim of this project is to contribute to the literature on vertical differentiation (VD) models with endogenous quality, both in terms of theory as well as applications.
Our first task is a systematic review of the literature on vertical differentiation. We aim to classify the existing literature depending on the assumptions on the costs of quality improvements, the distribution of consumers and whether the market is fully covered or not. These assumptions are crucial to explain the diversity of the existing results. In addition we intend to identify some popular themes in the literature and summarize the main results on these themes. This task will also identify gaps in the existing literature and provide directions for future research.
In the following tasks we consider a setup where the unit production costs are increasing with quality and we take into account that that whether there is partial coverage or full coverage of the market is determined endogenously when firms choose their quality, an issue that has been largely ignored in the VD literature.
The second task studies in detail the Nash equilibrium of the price game (for the various quality vectors), always considering the various types of market coverage and next derives the best response functions in the quality choice stage game. We may need to perform numerical analysis to characterize the subgame perfect Nash equilibrium of the quality-price game. In order to do numerical analysis, we will develop the programs using the software GAUSS.
The VD literature takes into account the fact that market coverage should be endogenously determined. In our third task we aim to identify the conditions under which each type of market coverage configuration holds, when unit production costs are increasing with quality.
A popular theme in the VD literature is related with the question of who reaps the larger profit: the low-quality firm or the high-quality firm? In our fourth task we revisit this issue considering a fully covered market with a corner solution in the price game, a case which may holds for a relatively wide interval of the quality valuation parameter.
The fifth task adapts our model of VD to the housing market, which implies considering location as another dimension of differentiation. Thus we consider a multidimensional VD model where two urban land developers first simultaneously choose the quality of housing and then simultaneously choose prices. We will examine how the quality choices depend on the location of the houses want to derive implications regarding the equilibrium degree of quality differentiation and the welfare level as transportation costs increase.
The sixth task comprises laboratory experiments to test the robustness of the results under experimental economics analysis, an issue that ripens the VD applications. The BELEM@UA (the recent created laboratory in DEGEIT - University of Aveiro) will be the laboratory chosen to conduct experiments.
Goals, activities and expected/achieved results
Goals
This project will study firms’ decisions regarding the quality of their products when unit costs increase with quality. We will develop theoretical models and validate them using experimental economics. We will take the housing market (HM) as our leading application, where building a higher quality house may require the use of more energy-efficient resources and more innovative materials. Our contributions will be mainly on the consideration of quality-dependent unit costs and that the partial or full coverage of the market is determined endogenously, issue that has been almost ignored in the literature but that may have important impacts in terms of welfare analysis. The HM model presents additional challenges as the house location brings another differentiation dimension. We will study how the house's location influences the quality choices of the urban land developers, in order to provide policy guidance to promote the construction of more energy- efficient and innovative buildings.
Activities
Our first task is a systematic review of the literature on vertical differentiation. We aim to classify the existing literature depending on the assumptions on the costs of quality improvements, the distribution of consumers and whether the market is fully covered or not. These assumptions are crucial to explain the diversity of the existing results. In addition we intend to identify some popular themes in the literature and summarize the main results on these themes. This task will also identify gaps in the existing literature and provide directions for future research.
In the following tasks we consider a setup where the unit production costs are increasing with quality and we take into account that that whether there is partial coverage or full coverage of the market is determined endogenously when firms choose their quality, an issue that has been largely ignored in the VD literature.
The second task studies in detail the Nash equilibrium of the price game (for the various quality vectors), always considering the various types of market coverage and next derives the best response functions in the quality choice stage game. We may need to perform numerical analysis to characterize the subgame perfect Nash equilibrium of the quality-price game. In order to do numerical analysis, we will develop the programs using the software GAUSS.
The VD literature takes into account the fact that market coverage should be endogenously determined. In our third task we aim to identify the conditions under which each type of market coverage configuration holds, when unit production costs are increasing with quality.
A popular theme in the VD literature is related with the question of who reaps the larger profit: the low-quality firm or the high-quality firm? In our fourth task we revisit this issue considering a fully covered market with a corner solution in the price game, a case which may holds for a relatively wide interval of the quality valuation parameter.
The fifth task adapts our model of VD to the housing market, which implies considering location as another dimension of differentiation. Thus we consider a multidimensional VD model where two urban land developers first simultaneously choose the quality of housing and then simultaneously choose prices. We will examine how the quality choices depend on the location of the houses want to derive implications regarding the equilibrium degree of quality differentiation and the welfare level as transportation costs increase.
The sixth task comprises laboratory experiments to test the robustness of the results under experimental economics analysis, an issue that ripens the VD applications. The BELEM@UA (the recent created laboratory in DEGEIT - University of Aveiro) will be the laboratory chosen to conduct experiments.
Results
This project aims to contribute to the literature on Vertical Differentiation focusing on relevant and advanced research topics. Therefore, we aim to publish five to seven articles in top international journals, among those included in the Journal Citation Reports/ISI Web of Knowledge. All researchers will participate in international conferences every year so as to get comments and discuss with other researchers, and also present the preliminary working paper versions of these articles in seminars of several Portuguese economics research units. We will organize one annual conference inviting keynote speakers with relevant related work on vertical differentiation analysis. Last, we aim to present an annual report so as to control the project evolution.
Therefore, our estimated output aim is to:
- publish the preliminary versions of our work in the Working Paper Series of the participating research units. We aim to publish around six new Working Papers related to this project
- present the preliminary working paper versions of these articles in seminars of several Portuguese economics research units, including the research units of our team members
- present the preliminary working paper versions of these articles in around six international conferences (namely European Association for Research in Industrial Economics Conference, UECE Lisbon Meetings: Game Theory and Applications and other adequate symposia)
- publish five to seven articles in top international journals, among those included in the Journal Citation Reports/ISI Web of Knowledge. More specifically, the journals we will target are International Journal of Industrial Organization, International Journal of Game Theory, Journal of Industrial Economics, Games and Economic Behavior and Experimental Economics
- organize one annual conference on Vertical Differentiation focusing all the main topics in our project
