VERTICAL PRODUCT DIFFERENTIATION WITH ENTRY

This paper examines the non-cooperative behaviour of established firms that compete in product quality and prices while foreseeing the effects of their rivalry on the decisions made by the later entrants. We prove an existence and uniqueness of the equilibrium and show that the dominant firms engage in maximal product differentiation, i.e., select the highest and lowest technologically feasible qualities. Later entrant, however, always selects an intermediate quality. Moreover, we show that the equilibrium configuration is identical to that generated by perfect foresight equilibrium in a model of sequential entry. Furthermore, the profits earned by each firm are ranked in the same order as the qualities, implifying that the later entrant, despite being the last mover, ends up with higher profits and larger market share than one of the incumbents.