DP7560 A Dynamic Quality Ladder Model with Entry and Exit: Exploring the Equilibrium Correspondence Using the Homotopy Method

Author(s): Ron N. Borkovsky, Ulrich Doraszelski, Yaroslav Kryukov
Publication Date: November 2009
Keyword(s): computation, dynamic stochastic games, homotopy method, Markov perfect equillibrium
JEL(s): C63, C73
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=7560

This paper explores the equilibrium correspondence of a dynamic quality ladder model with entry and exit using the homotopy method. The homotopy method facilitates exploring the equilibrium correspondence in a systematic fashion; it is ideally suited for investigating the economic phenomena that arise as one moves through the parameter space and is especially useful in games that have multiple equilibria. We discuss the theory of the homotopy method and its application to dynamic stochastic games. We then present the following results: First, we find that the more costly and/or less beneficial it is to achieve or maintain a given quality level, the more a leader invests in striving to induce the follower to give up; the more quickly the follower does so; and the more asymmetric is the industry structure that arises. Second, we show that the possibility of entry and exit alone gives rise to predatory and limit investment. Third, we illustrate and discuss the multiple equilibria that arise in the quality ladder model, highlighting the presence of entry and exit as a source of multiplicity.