Unilateral Spillovers Between East and West and Quality Competition

Abstract

We model a two-stage duopolistic competition in a vertically differentiated eastern market between the eastern and western firms. In the first stage firms compete in R&D, and in the second stage in prices. Consumers in eastern market are distributed uniformly according to their income, and purchase at most a single unit of the product. The R&D activity improves the quality of the product. There are unilateral spillovers from the western firm which produces the higher quality to the eastern firm which produces the lower quality. The eastern firm can also imitate, to some degree, the western product. We show that if (1) not all consumers have purchased the good initially, (2) the eastern firm has a high rate of absorbing information out of the western firm, (3) the western firm does no learn from the eastern firm, then no firm may have an incentive to deviate unilaterally from the equilibrium in which the eastern firm is the leader an the western firm is the follower. We compare this equilibrium with the one in which only the western firm conducts R&D; the eastern firm increases the quality of its product solely through imitation. We show that under assumptions (1)-(3) listed above and for absorption rate close to 1, the welfare level in the eastern country is higher when the eastern firm imitates only compared to the welfare level in the leader-follower equilibrium.