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Market Experimentation in a Dynamic Differentiated-Goods Duopoly

  • Godfrey Keller

    (London School of Economics)

  • Sven Rady

    (Graduate School of Business, Stanford University)

We study the evolution of prices in a symmetric duopoly where firms are uncertain about the degree of product differentiation. Customers sometimes perceive the products as close substitutes, sometimes as highly differentiated. Firms learn about their competitive environment from the quantities sold and a background signal. As the informativeness of the market outcome increases with the price differential, there is scope for active learning. In a setting with linear demand curves, we derive firms' pricing strategies as payoff-symmetric mixed or correlated Markov perfect equilibria of a stochastic differential game where the common posterior belief is the natural state variable. When information has low value, firms charge the same price as would be set by myopic players, and there is no price dispersion. When firms value information more highly, on the other hand, they actively learn by creating price dispersion. This market experimentation is transient, and most likely to be observed when the firms' environment changes sufficiently often, but not too frequently.

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Paper provided by EconWPA in its series Game Theory and Information with number 9810001.

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Length: 37 pages
Date of creation: 16 Oct 1998
Date of revision: 20 Aug 1999
Handle: RePEc:wpa:wuwpga:9810001
Note: Type of Document - Acrobat PDF; prepared on PC; pages: 37 ; figures: included
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