On the Effects of Raised Rival's Costs

Review of Industrial Organization, 2022

Sreya Kolay and Rajeev K. Tyagi

Abstract

It is commonly believed that a firm gains a strategic advantage and improves its profitability from an increase in its rival's costs. This paper examines the effects of a rival's cost increase in a vertically differentiated market with endogenous product qualities. It provides cost-side and demand-side conditions under which a firm loses from its rival's cost increase. We show how the gain or loss depends on: (i) the absence or presence of outside options for consumers; (ii) the degree of heterogeneity in consumer taste for quality; (iii) whether the cost of producing quality involves fixed costs or variable costs; and (iv) the relative quality-production efficiencies of the competing firms.

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