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JOURNAL OF OPTIMIZATION THEORY AND APPLICATIONS: Vol. 119, No. 2, pp.

261–280, November 2003 ( 2003)

Dynamic Advertising under Vertical Product Differentiation1
L. COLOMBO2
AND

L. LAMBERTINI3

Communicated by G. Leitmann

Abstract. We investigate a dynamic advertising model where product 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 distortion being concerned with the output levels. Key Words. Advertising, product quality, differential games, optimal control.

1. Introduction There exists a wide literature dealing with dynamic advertising either in monopoly model or in oligopoly model; see Refs. 1–3 and Ref. 4 (Chapter 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 optimal control of advertising efforts and product quality in relation with building 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.

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

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approaches, the strategic use of product qualities as the firms instruments 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 different 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 profits 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 interaction between quality and advertising is disregarded completely and the equilibrium 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 literature 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.

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The remainder of the paper is structured as follows. The basic setup is 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 Traditionally, models dealing with vertically differentiated duopoly 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 consumers 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 market 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 satisfaction 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, ˆ θ (t)G[ pH (t)ApL (t)AqH (t)CqL (t)] (1As), (4)

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and the analogous threshold of θ characterizing the consumer who is indifferent between buying from the low quality firm and not buying at all, ˜ θ (t)G[ pL (t)AqL (t)] s. The direct demand system follows the relations ˆ xH (t)Gθ 1Aθ (t), ˆ ˜ xL (t)Gθ (t)Aθ (t), (6) (7) (5)

˜ provided that θ (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), pL (t)GqL (t)Cs[θ 1AxH (t)AxL (t)]. (8) (9)

Observe that the relations (4)–(9) define correctly the demand system if and ˆ ˜ only if θ (t)„ θ (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 technological 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,
2

(10)

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) ∂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 θ (t) down] as well ˆ (t) up], while the as in the intermediate range of preferences [i.e., pushing θ ˆ high-quality firm can fight only against the rival for θ (t), since the upper

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bound of the willingness to pay θ 1 is given. This preludes to the possibility 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
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), where
ˆ θ (t)

(13)

CSL (t)G
˜ θ (t)

(szCqL (t)ApL (t)) dz (14)

Gs[xL (t)]2 2,
θ1

CSH (t)G
ˆ θ (t)

(zCqH (t)ApH (t)) dz (15)

G[xH (t) 2] [xH (t)C2sxL (t)].

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 current value Hamiltonian function of firm i is

H i (t)Ge −ρt[π i (t)Cλ ii (t)xiCλ ij (t)x j ]. ˙ ˙

(17)

The first-order conditions (FOCs) on the controls are (henceforth, we omit the indication of time for brevity)6 ∂H i ∂qi G0 ⇒ xi (1A2ci qi)G0 ⇒ qi G1 2ci , ˙ ∂H i ∂ai G0 ⇒ A2ai biCλ ii G0 ⇒ λ ii G2ai bi ⇒ λ ii G2ai bi . ˙
6

(18) (19)

Second-order conditions are always met throughout the paper. They are omitted for brevity.

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The above FOCs entail that the present game is a linear state game, producing 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, ∂H H ∂xH G−δλ HHCθ 1CqHAcH q2 A2xHAsxL H ˙ Gρλ HHAλ HH , ∂H L ∂xL G−δλ LLCqLAcL q2 Cs(θ 1AxHA2xL) L ˙ Gρλ LLAλ LL , along with the transversality condition lim µi (t)xi (t)G0 (22) (21) (20)

t→S

and the initial conditions xi (0)H0. Now, using (19) and the costate equations, we write ˙ aH Gλ HH 2bH G−1 4cHAθ 1C2aH bH (δCρ)C2xHCsxL , ˙ ˙ aL Gλ LL 2bL G−1 4cLC2aL bL (δCρ)Cs(−θ 1CxHC2xL). ˙ The steady-state equilibrium requires aH G0, aL G0, yielding ˙ ˙ aH G[1C4cH (θ 1A2xHAsxL)] 8bH cH (δCρ), aL G[1C4cL s (θ 1AxHA2xL)] 8bL cL (δCρ), (25) (26) (23) (24)

which can be plugged into the system of state equations (11), simplifying as follows: xH G[1C4cH (θ 1A2xHAsxL)] 8bH cH (δCρ)Aδ xH , ˙ xL G[1C4cL s(θ 1AxHA2xL)] 8bL cL (δCρ)Aδ xL . ˙
7 8

(27) (28)

See e.g. Refs. 23–24. For an exhaustive exposition of linear state games, see Ref. 4 (Chapter 7). 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.

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Fig. 1. Parameter space.

We are interested in investigating the dynamics of the system in the positive quadrant of the space {xi , ai }, which is described in Fig. 1. The system ˙ ˙ {xi G0, ai G0} yields the following steady-state sales: xSS G H
xSS G L

2bL cL δ (1C4cH θ 1)(δCρ)As{−2cLCcH [1C4cL θ 1 (sA2)]}
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)]
4cH cL (4bL δ (δCρ){1CbH δ (δCρ)C[4C4bH δ (δCρ)As]s}

,
.

(29)
(30)

These expressions can be plugged into (25)–(26) to yield the optimal investments in advertising, aSS . The following proposition holds. i Proposition 3.1. The steady state defined by {aSS , xSS } is a saddle i i point. Proof. See the Appendix (Section 6). The above output levels are acceptable if and only if they are nonnegative. 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 is positive i 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 interaction with production cost parameters ci. We can prove the following lemma. Lemma 3.1. The equilibrium output of the high-quality firm xSS is H always positive. Proof. Examine the numerator of (29). The first term, 2bL cL δ (1C4cH θ 1)(δCρ),

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is clearly positive. Then, it can be quickly established that −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 . Now, we examine the output of the low-quality firm. Lemma 3.2. If cH ∈(cL s 2(1C2cL θ 1 s), cL), then xSS H0 for all bH H0. If instead, L cH ∈(0, cL s 2(1C2cL θ 1 s)], then xSS H0 for all L ¯ bH HbH ≡ scLA2cH (1C2cL θ 1 s)
2δ cH ( ρCδ )(1C4θ 1 cL s) „0.

¯ Otherwise, xSS G0 for all bH ∈[0, bH ]. L Proof. In general, xSS H0 for all L scLA2cH (1C2cL θ 1 s) ¯ bH HbH ≡ . 2δ cH ( ρCδ )(1C4θ 1 cL s)
This is surely true for all admissible bH if cH ∈(cL s 2(1C2cL θ 1 s), cL), ¯ since this implies bH F0. In the case where cH ∈(0, cL s 2(1C2cL θ 1 s)], ¯ then bH „0. Therefore, in this range of cH, we have that xSS „0 iff L ¯ H . This concludes the proof. bH „b Now, on the basis of Lemma 3.2, one can also check that, in equilibˆ ˆ ˜ ˜ rium, the nonnegativity of xSS ≡ θ (t)Aθ (t) ensures also that θ (t)„ θ (t). L Lemmas 3.1 and 3.2 imply directly a relevant corollary. Corollary 3.1. If cH ∈(0, cL s 2(1C2cL θ 1 s)], then the high-quality firm ¯ is monopolist for all bH ∈[0, bH ].

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When the efficiency of the advertising technology of firm H is very high (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 HxSSCxSS ; H L
i.e., indeed, firms cover the market only partially. Lemma 3.3. θ 1 HxSSCxSS for all bHHmax{bH , 0}, where ¡ H L bH ≡ ¡ cL [sC2bL δ (δCρ)]CcH [2A8bL cL δθ 1 (δCρ)As(1C4cL θ 1)]
2cH δ (δCρ){4cL θ 1 [2bL δ (δCρ)Cs]A1} ,

with ∂bH ∂bL F0 always. ¡ Proof. The derivation of bH is straightforward. Then, observe that ¡ ∂bH cL [1C4cH θ 1 (1As)] ¡ G− F0. ∂bL cH {4cL θ 1 [2bL δ (δCρ)Cs]A1}2
The above result entails that, intuitively, partial market coverage is 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]} ˆ bH ≡ 2cH δ (δ + ρ)(1+4cL θ 1 s)
(31)

as the level of bH such that xSS GxSS . Assessing xSSAxSS , one can prove H L H L easily the following lemma.9 ˆ ˆ Lemma 3.4. If bH H0, then xSS HxSS for all bH ∈(0, bH); xSS FxSS for H L H L ˆ H . If instead bH ‚0, then xSS HxSS . ˆ all bH Hb L H 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 SS ˆ the value of bH such that xH AxL G0 is unique and it is given by bH .

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We now turn to the comparative statics on the steady-state level of sales w.r.t. all parameters. First, the property ∂xSS ∂c j H0, i ≠ j, can be interi preted easily. All else being equal, as firm j becomes less efficient in supplying 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 ∂ci F0. i Not surprisingly, ∂xSS ∂θ 1 H0. i 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 ∂xSS ∂bH F0, H ∂xSS ∂bH H0, L (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 expensive (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 xSS is more involved, i ∂xSS ∂bL H0 and ∂xSS ∂bL F0, H L cH G ˜ scL
2[1C2cL θ 1 sCbH δ (1C4cL θ 1 s)(δCρ)]

for all cH HcH , ˜

(33)
(34)

and conversely for all cH ∈(0, cH ]. This means that, when vertical product ˜ differentiation is relatively low (which holds when cH HcH ), any increase in ˜ bL drives some consumers to switch from the inferior variety to the highquality 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,

π SS G H

[1CbH δ (δC2ρ)]Ω2
16c2 c2 [4bL δ (δCρ)[1CbH δ (δCρ)]C[4C4bH δ (δCρ)As]s]2 H L [bL δ (δC2ρ)Cs]Ψ2
16c c [4bL δ (δCρ)[1CbH δ (δCρ)]C[4C4bH δ (δCρ)As]s]2
2 2 H L

,

(35) (36)

Ω ≡ cH [1C4cL θ 1 (−2Cs)]sA2bL cL δ (1C4cH θ 1)(δCρ)A2cL ,

π SS G L

,

(37) (38)

Ψ ≡ cL sA2cH [1C2cL θ 1 sCbH δ (δCρ)(1C4cL θ 1 s)].

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By evaluating the sign of the difference between π SS and π SS , we obtain a H L ˜ critical value bH at which π SS Gπ SS entailing the following lemma.10 H L ˜ ˜ Lemma 3.5. If bH H0, then π SS Hπ SS for all bH ∈(0, bH); π SS Fπ SS for H L H L ˜ H . If instead bH ‚0, then π SS Hπ SS . ˜ all bH Hb L H ˆ ¯ Moreover, comparing bH against bH , we obtain the following lemma. ˆ ¯ Lemma 3.6. bH HbH always. Proof. It suffices to observe that ˆ ¯ bHAbH 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 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 parameter of high-quality firm, bH. This partition is illustrated in Fig. 1, assuming that the parameter set is such that ˆ ˜ bH HbH H0Hmax{bH , bH }. ¡ ¯ This means that we exclude the trivial case where the market is a monopoly for firm H. ˆ ˜ Proposition 3.2. Take values of {s, θ 1 , ci } such that bH HbH H0. If ˆ H), then xSS HxSS , aSS HaSS , and π SS Hπ SS . If bH ∈(bH , bH), then ˆ ˜ bH ∈(0, b H L H L H L ˜ xSS FxSS , aSS FaSS , and π SS Hπ SS . If bH HbH , then xSS FxSS , aSS FaSS H L H L H L H L H L and π SS Fπ SS . H L The above proposition illustrates a situation where the parameter 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 differentiation 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,
SS SS The equation π H Gπ L 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). 10

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ˆ ˜ consider that the critical levels bH and bH are a function of bL. Then, examˆ ine the case bH ∈(0, bH). Here, the advertising technology of firm H is sufficiently efficient, as compared to that of firm L, to imply that firm H acquires ˆ ˜ a dominant position in the market. If instead bH ∈(bH , bH), 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 HbH , 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. ˆ ˜ Observe that, in line of principle, bH HbH 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 ˜ ˆ that initially π SS Hπ SS , then π SS Fπ SS for bH ∈(bH , bH), then again H L H L ˆ π SS Hπ SS for bH HbH . For this reason, we can dismiss such a case. H L

4. Monopoly and Social Planning Now, we examine the regimes where, both plants are controlled, respectively, by (i) a profit-seeking monopolist and by (ii) a benevolent planner maximizing social welfare. In the monopoly regime (M), the current value Hamiltonian function turns out to be

H M Ge −ρt (π HCπ LCλ H xHCλ L xL), ˙ ˙
while under social planning (SP), we have

(39)

H SP Ge −ρt (WCλ H xHCλ L xL), ˙ ˙

(40)

where the instantaneous social welfare function W is defined as in (16). The first relevant result is stated in the following proposition. Proposition 4.1. Under both monopoly and social planning, the optimal qualities are the same as under the profit-seeking duopoly (D):

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qk G1 2ci , i

iGH, L and kGD, M, SP.

Proof. To show this, it suffices to observe that, irrespective of the 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

∂qi G∂H

D i

∂qi G∂π i ∂qi G0,

since the consumer surplus is independent of quality levels. Another obvious result needs no proof. This regards the profit performance of the industry in the three regimes at stake. Clearly, the highest attainable 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-seeking 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. Proposition 4.2. Under monopoly, the optimal advertising efforts for generic output levels are aM G H
aM G L

1C4cH (θ 1A2xHA2sxL)
8bH cH (δCρ) 1C4cL s(θ 1A2xHA2xL)
8bL cL (δCρ)

,
,

while the steady-state output levels are xM G H
xM G L

bL cL δ (1C4cH θ 1)(δCρ)Cs[cLCcH (−1C4cL θ 1A4cL sθ 1)]
8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s} −cL sCcH (1CbH δ (δCρ)(1C4cL θ 1 s))
8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s} .

,

The monopoly equilibrium is a saddle point. Proof. See the Appendix (Section 6). If a planner controls both firms, we obtain the following proposition.

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Proposition 4.3. Under social planning, the optimal advertising efforts for generic output levels are aSP G H
aSP G L

1C4cH (θ 1AxHAsxL)
8bH cH (δCρ) 1C4cL s(θ 1AxHAxL)
8bL cL (δCρ)

,
,

while the steady-state output levels are xSP G H
xSP G L

2bL cL δ (1C4cH θ 1)(δCρ)Cs[cLCcH (−1C4cL θ 1A4cL sθ 1)]
4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s} −cL sCcH [1C2bH δ (δCρ)(1C4cL θ 1 s)]
4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s}

,
.

The social optimum is a saddle point. Proof. See the Appendix (Section 6). One last remark is in order, concerning the different incentives to invest 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.

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together with the appropriate expressions of optimal advertising efforts in the three regimes, produce the following proposition. Proposition 4.4. For a given xj it follows that aiSP HaiD HaM implying i that xiSP HxD HxM . i i As the planner aims at maximizing the sum of profits and consumer 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 singleproduct 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 We have proposed a differential duopoly game where each firm may 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 Proof of Proposition 3.1. We consider first the system composed by (11) in combination with the appropriate kinematics of the control variable

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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: ˙ xH −δ G ˙ aH 2 1 xH 0 C , 2bH (δCρ) aH sxLA1 (4cH)Aθ 1 xL aL C 0 . sxHA1 (4cL)Asθ 1

˙ xL −δ 1 G ˙ 2s 2bL (δCρ) aL

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.

Fig. 3. Phase diagram.

Numerical Duopoly Example. Take the following numerical values of the parameters:

θ 1 G1,
cL G3 4, If so, then

bL G1 10, sG9 10,

cH G7 10,

(41a) (41b)

δ Gρ G1 20.

π SS Hπ SS , L H

˜ for all bH HbH

22.105.

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Setting bH G22.3, the numerical values of the equilibrium variables are

π SS H

0.2037,

π SS L

0.2041,

xSS H

0.4178,

xSS G0.4760. L

(42)

Proof of Proposition 4.2. The first-order conditions relative to the Hamiltonian (39) are ∂H ∂H ∂H ∂H
M

∂qi G0 ⇒ xiA2ci qi xi G0 ⇒ qi G1 2ci , ˙ ∂ai G0 ⇒ A2ai biCλ i G0 ⇒ λ i G2ai bi ⇒ λ i G2 ai bi , ˙ ˙ ∂xH G−δλ HCθ 1CqHAcH q2 A2xHA2sxL Gρλ HAλ H , H ˙ ∂xL G−δλ LCqLAcL q2 Cs (θ 1A2xHA2xL)Gρλ LAλ L , L

(43) (44) (45) (46)

M

M

M

along with the same initial and transversality conditions as in the duopoly. From (45) and (46), we have ˙ λ H G(δCρ)λ HAθ 1AqHCcH q2 C2xHC2sxL , (47) H ˙ λ L G(δCρ)λ LAqLCcL q2 As (θ 1A2xHA2xL), L while from (44), ˙ aH Gλ H 2bH G−1 4cHAθ 1C2aH bH (δCρ)C2xHC2sxL , ˙ ˙ aL Gλ L 2bL G−1 4cLC2aL bL (δCρ)Cs (−θ 1C2xHC2xL). ˙ The steady-state equilibrium requires {aH G0, aL G0} ˙ ˙ aM G H 1C4cH (θ 1A2xHA2sxL)
8bH cH (δCρ) 1C4cL s(θ 1A2xHA2xL)
8bL cL (δCρ)

(48) (49) (50)

,
.

(51a)
(51b)

aM G L

Then, simplifying the state kinematics yields ˙ xH G
˙ xL G

1C4cH (θ 1A2xHA2sxL)
8bH cH (δCρ)Aδ xH
8bL cL (δCρ)Aδ xL

, −dxH ,

(52)
(53)

1C4cL s(θ 1A2xHA2xL)

, −dxL .

At the resulting unique steady state, the sales are xSS G H
xSS G L

bL cL δ (1C4cH θ 1)(δCρ)Cs[cLCcH (−1C4cL θ 1A4cL sθ 1)]
8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s} −cL sCcH [1CbH δ (δCρ)(1C4cL θ 1 s)]
8cH cL (bL δ (δCρ){1CbH δ (δCρ)C[1CbH δ (δCρ)As]s} .

,

(54)
(55)

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The dynamic system can be written in the matrix form xH ˙ aH ˙ xL ˙ aL ˙ −δ 2 G 0 2s 1 0 2bH (δCρ) 2s 0 −δ 0 2s 0 0 1 2bL (δCρ) xH aH xL aL 0 −1 4cHAθ 1 C . 0 −1 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. Proof of Proposition 4.3. The first-order conditions relative to the social planner Hamiltonian (40) are ∂H ∂H ∂H
SP

∂qi G0 ⇒ xiA2ci qi xi G0 ⇒ qi G1 2ci , ˙ ∂ai G0 ⇒ A2ai biCλ ii G0 ⇒ λ ii G2ai bi ⇒ λ ii G2ai bi , ˙ ∂xH G−δλ HCθ 1CqHAcH q2 AxHAsxL H ˙ Gρλ HHAλ HH ,

(56) (57)

SP

SP

(58) (59)

∂H

SP

∂xL G−δλ LLCqLAcL q2 Cs (θ 1AxHAxL) L ˙ Gρλ LLAλ LL ,

with the same initial and transversality conditions as in the previous cases. From (58) and (59), we have ˙ λ H G(δCρ)λ HAθ 1AqHCcH q2 CxHCsxL , H ˙ λ L G(δCρ)λ LAqLCcL q As(θ 1AxHAxL),
2 L

(60) (61)

while from (57), ˙ aH Gλ H 2bH G−1 4cHAθ 1C2aH bH (δCρ)CxHCs xL , ˙ ˙ aL Gλ L 2bL G−1 4cLC2aL bL (δCρ)Cs (−θ 1CxHCxL). ˙ The steady-state equilibrium requirement {aH G0, aL G0} yields ˙ ˙ aSP G H 1C4cH (θ 1AxHAsxL)
8bH cH (δCρ)
8bL cL (δCρ)

(62) (63)

,
,

(64a)
(64b)

aSP G L

1C4cL s (θ 1AxHAxL)

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that can be used to rewrite the state equations as ˙ xH G 1C4cH (θ 1AxHAsxL) , −dxH , 8bH cH (δCρ)Aδ xH
(65)
(66)

1C4cL s(θ 1AxHAxL) ˙ xL G , −dxL . 8bL cL (δCρ)Aδ xL
˙ ˙ Solving the system {xH G0, xL G0}, one obtains the steady-state sales, xSS G H
xSS G L

2bL cL δ (1C4cH θ 1)(δCρ)Cs[cLCcH (− 1C4cL θ 1A4cL sθ 1)]
4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s} −cL sCcH [1C2bH δ (δCρ)(1C4cL θ 1 s)]
4cH cL (2bL δ (δCρ){1C2bH δ (δCρ)C[1C2bH δ (δCρ)As]s} −δ 1 G 0 s

,
.

(67)
(68)

Finally, the dynamic system can be written in the matrix form ˙ xH ˙ aH ˙ xL ˙ aL 1 0 2bH (δCρ) s 0 −δ 0 s 0 0 1 2bL (δCρ) xH aH xL aL 0 −1 4cHAθ 1 0 −1 4cLAsθ 1

C

.

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.

References
1. JØRGENSEN, S., A Surûey of Some Differential Games in Adûertising, Journal of Economics Dynamics and Control, Vol. 4, pp. 341–369, 1982. 2. ERICKSON, G. M., Dynamic Models of Adûertising Competition, Kluwer, Dordrecht, Holland, 1991. 3. FEICHTINGER, G., HARTL, R. F., and SETHI, P. S., Dynamic Optimal Control Models in Adûertising: Recent Deûelopments, Management Science, Vol. 40, 195–226, 1994. 4. DOCKNER, E. J., JØRGENSEN, S., LONG, N. V. and SORGER, G., Differential Games in Economics and Management Science, Cambridge University Press, Cambridge, UK, 2000. 5. SCHMALENSEE, R., A Model of Adûertising and Product Quality, Journal of Political Economy, Vol. 86, pp. 1213–1225, 1978. 6. KOTOWITZ, Y., and MATHEWSON F., Adûertising, Consumer Information, and Product Quality, Bell Journal of Economics, Vol. 10, pp. 566–588, 1979.

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