Kurt R. Brekke, Roberto Cellini, Luigi Siciliani, and Odd Rune Straume
We investigate the effect of competition on quality in regulated markets (e.g., health care, higher education, public utilities), using a Hotelling framework, in the presence of sluggish beliefs about quality. We take a differential-game approach, and derive the open-loop solution (providers choose the optimal quality investment plan based on demand at the initial period) and the feedback closed-loop solution (providers observe demand in each period and choose quality in response to current demand). If variable costs are strictly convex, and the degree of cost complementarity between quality and output is not too strong, the steady-state quality is higher under the open-loop solution than under the feedback solution. In both solutions, quality and demand move in opposite directions over time on the equilibrium path to the steady-state. While lower transportation costs or less sluggish beliefs lead to higher quality in both solutions, the quality response is weaker when players use feedback strategies.