Risky quality choice

In vertical product differentiation with a stochastic research technology, firms should target their research at different quality levels for efficiency. In a natural monopoly where the top firm finds it most profitable to sell to the whole market, the incentives for risk-taking and for firms to differentiate their targeted qualities are optimal. In a natural oligopoly (which results when there is sufficient dispersion of tastes), the relationship between a firm's payoff and its quality improvement over other firms is weakened. This diminishes the firms' incentives to differentiate and the targeted qualities are too low and too close together. (C) 2001 Elsevier Science B.V. All rights reserved.