Product differentiation under loss aversion and demand uncertainty

Abstract

This thesis analyzes, first, the relationship between loss aversion and demand uncertainty for vertical product differentiation, and second, the effect of loss aversion on the degree of horizontal product differentiation. In the vertical product differentiation model, we consider a three-stage duopoly game setting, where we incorporate demand uncertainty. Firms have incomplete information about the buyers’ true types and they face demand uncertainty. They announce their qualities before the demand uncertainty is resolved, and they announce their prices after the demand uncertainty is resolved. We find the subgame perfect Nash equilibrium for qualities and prices, and we also calculate the profit of each firm as well as the consumer surplus. We also conduct comparative statics to explain how loss aversion affects the outcomes, including the qualities, prices, profits and consumer surplus. We show that, for a wide variety of utility functions, the high quality firm’s equilibrium quality, and the equilibrium prices increase with the degree of loss aversion. Also, both firms benefit from a stronger loss aversion, but consumers are worse off when loss aversion is stronger. For the horizontal product differentiation model, we also consider a three-stage duopoly game setting, where the firms compete in locations in the first stage, before the buyers determine their reference locations, and compete in prices in the third stage, after the buyers determine their reference locations. Assuming that one firm has a cost advantage, we show that for a range of the degree of the cost advantage, the equilibrium exhibits maximal product differentiation under loss aversion, while we get minimal product differentiation when there is no loss aversion.