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The Incentives for Cost Reduction in a Differentiated Industry

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~ t~R Discussion for a ermic Research I!~III IIIIIIIIIIIIII INIIIIIIIIll~él~~I~I No. 9136 THE INCENTIVES FOR COST REDUCTION IN A DIFFERENTIATED INDUSTRY by Helmut Bester . ~ and Emmanuel Petrakis ,' y ~~ Ju1y 1991 1SSN o924-7815 THE INCENTIVES FOR COST REDUCTION IN A DIFFERENTIATED INDUSTRY Helmut Bester' and Emmanuel Petrakist Abetract This paper inveetigates the incentivea for cost reduction in a differentiated industry. It romparea price and quantity competition and the social optimum. Typically the results depend upon the degree of product substitutabílity. When goods aze imper[ect subatitutes, both Cournot and Bertrand competition reault in underinvestment in cost reduction. Overinvestment may occur when the goods are sufficiently close substitutes. Similazly, Cournot competition provides a stronger incentive to innovate than Bertrand competition if the degree of substitutability is low, and a weaker incentive if this degree is high. 'CentER, Tilburg University, P.O. Box 90153, 5000 LE Tilburg, The Netherlande ~CentER, Tilburg University, P.O. Box 90153, 5000 LE Tilburg, The Netherlands, and Erasmus Univereity, P.O. Box 1738, 3000 DR Rotterdam, The Netherlande 1 1 Introduction This paper investigates the incentives for cost-reducing innovation in a differentiated in- dustry. We compare Lwo alteruative categories of product market cornpetition, Cournot and Bertrand, and the social optimum. Our framework allows us to address the ques- tion of how the degree of substitutability of producta affects this comparison. Indeed, our analysis reveals that this degree has an important impact on the incentives to inno- vate. For example, we establish that both Cournot and Bertrand competition lead to underinvestment in cost reduction relative to the social optimum when the firms enjoy a quasi-monopolistic position because the customera of each firm regard the brand of the other firm as a poor substitute. But, when product competition is increased and g

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