Motivation
Product recalls are frequent and costly. A firm that launches an innovation without thorough quality assurance testing gains time on the market but risks a recall, which brings direct costs (repairs, refunds, legal settlements) and lasting damage to the product's reputation. Testing removes the risk but delays the launch, and while a firm tests, a rival can take the market with its own innovation. Kim, Koenigsberg and Ofek (SSRN 3492105, November 2019; published in Management Science, 2022, doi:10.1287/mnsc.2022.4303) model this trade-off as a two-period game and ask when competing firms test and when they rush to market. Their answer for two identical firms, Proposition 2, is the goal of this mission: depending on the failure probability of an untested product, neither firm tests, both test, or exactly one tests.
Setting
Two firms each hold an innovation. The mature product has quality V>0 and the innovation quality V+B, with B>0. Production costs nothing. There are two periods, t=1,2.
Before t=1, each firm chooses its testing decision QA∈{0,1} simultaneously. A firm that tests (QA=1) sells its mature product at t=1 and a fail-proof innovation at t=2. A firm that does not test (QA=0) launches its innovation at t=1. The untested innovation fails during that period with probability θ∈(0,1), independently across firms. On failure the firm pays a recall cost Δ=ρ+δπ1, where ρ>0 is a fixed cost, δ∈(0,1] a penalty per unit of first-period revenue and π1 the firm's first-period profit, and at t=2 it sells a recalled innovation of quality (V+B)(1−γ), with reputation damage γ∈(0,1).
In each period a new unit mass of consumers arrives, with tastes ϕ uniform on [0,1]. A consumer of taste ϕ gets utility ϕq−p from a product of quality q at price p and buys the product of greatest utility if that utility is nonnegative. Given the two products on offer, the firms set prices; the pricing subgame is the one-period price game, and its equilibrium profit for quality q against q′ is written π(q,q′). The testing game is the simultaneous 2×2 game in which a firm choosing a against a rival choosing b earns the expected two-period payoff Πa,b, and an equilibrium is a pure Nash equilibrium of it.
Formalization targets
Goal: Proposition 2
With the cutoffs of the paper's appendix,
θ~st=(V+B)(4B(V+B)(3+γ)2δ−(3V+4B)2(1−γ)γ)+(3V+4B)2(3+γ)2ρ4B(V+B)2(3+γ)2,
and θ~nt=[θ~nt,θ~nt], the interval between the two roots of the quadratic in θ given by (A.3):
no firm tests⟺θ∈θ~nt,both test⟺θ≥θ~st,exactly one tests⟺θ≤θ~st and θ∈/θ~nt,
and the two symmetric equilibria never coexist.
Milestones
- Lemma 1 (three bullets): the equilibrium prices and profits of the pricing subgame, namely mature product against innovation, innovation against recalled innovation, and Bertrand pricing at equal qualities.
- The four payoffs Π1,1=0, Π0,1, Π1,0, Π0,0 in closed form (proof of Proposition 2).
- (A.3) and (A.4): the best-response conditions Π0,0≥Π1,0⟺θ∈θ~nt and Π1,1≥Π0,1⟺θ≥θ~st.
- (A.5) and the ρ~nt bound: the recall-cost thresholds under which each cutoff lies in (0,1).
- Corollary 3: a dual-firm-test equilibrium requires ρ≥ρ~st, and ρ~st>ρ~nt.
Significance
Proposition 2 is the paper's main result for competition. It shows that competition changes the testing decision in two directions. A rival's early launch makes simultaneous rushing less costly, because identical products earn nothing in the first period and the revenue-based recall penalty then vanishes. Firms also try to differentiate their timing, which produces the asymmetric equilibrium in which one firm tests and the other does not. Comparing the result with the monopoly benchmark (Proposition 1) gives the paper's managerial conclusions: duopolists may skip a test that a monopolist would run (Corollary 2), and both firms test only when the fixed recall cost is large (Corollary 3).
The proofs in the paper are algebraic and partly omitted ("tedious algebra … available from the authors"). A formal development checks every case of the price equilibria, including the global deviations that the first-order conditions do not cover, and the exact boundaries of each equilibrium region. It also settles the boundary behaviour the paper leaves implicit: the regions are disjoint only off their boundaries. No machine-checked proof of any result of this paper is known.
Difficulty
Most of the work is in Lemma 1. The first-order conditions of the price game give the stated prices, but an equilibrium must also survive non-local deviations: the low-quality firm may undercut to take the whole market, and the high-quality firm may price below the region where both firms sell. Demand is piecewise in the prices, with kinks where one firm's market vanishes and a tie-splitting rule at equal qualities, so each best response is a maximization over several branches. The uniqueness half of the Bertrand bullet needs an undercutting argument. The cutoff characterizations then require sign control of a quadratic in θ whose discriminant can be negative, and of a denominator in θ~st that is negative for small ρ.
Formalization scope
All quantities are real numbers. The parameters are a structure with fields V,B,ρ,δ,γ,θ, and a predicate bundles the standing assumptions V>0, B>0, ρ>0, 0<δ≤1, 0<γ<1, 0<θ<1. The page writes neither V>0 nor B>0; both are implicit and are made explicit here.
Demand is the Lebesgue measure of the set of tastes in [0,1] that buy the product, with indifferent consumers counted with weight 21. A price equilibrium allows deviations to every nonnegative price. The period profit π(q,q′) is revenue at the prices computed in the proof of Lemma 1, 2q(q−q′)/(4q−q′) for the higher quality, q(q′−q)/(4q′−q) for the lower and 0 for equal qualities. It is computed from demand, so Lemma 1's profit formulas are theorems. The untested firm's objective (1−θδ)pd−θρ of (A.1) is a positive affine transform of revenue and has the same best responses, so the price game is posed on revenue.
Lemma 1 identifies the unique price equilibrium for each of the two differentiated quality pairs as well as for equal qualities. The payoff Πa,b is built from the recall events, each failing independently with probability θ, and from the period profits. Testing decisions are Booleans (true = test). Equilibria of the testing game are pure Nash equilibria with weak best responses, using the published agt_games predicate AGT.IsPureNash.
The cutoffs are written exactly as on p. 37. Every statement that uses θ~st requires its denominator to be positive, and every statement that uses θ~nt requires the discriminant to be nonnegative; when these fail, the corresponding region is empty. The paper calls its regions "mutually exclusive", but at the boundaries a symmetric and an asymmetric equilibrium coexist, so the goal asserts exclusivity only between the two symmetric equilibria.
Trivializing formalizations are ruled out. Defining the payoffs by the four closed forms of the paper's proof, or the period profits by Lemma 1's formulas, would make the milestones definitional and the goal pure algebra. Here both are built from consumer choice.
Not in scope: the monopoly benchmark (Proposition 1, Corollary 1), Corollary 2 (proved only in a limit), the comparative statics of Corollary 4, the conditions B<B~nt and γ~nt of (A.3), and the extensions of §5. Contributions are welcome on any milestone. Lemma 1's analysis of the vertical-differentiation price game with uniform tastes is reusable for other quality-competition models.
Selected references
- B. Kim, O. Koenigsberg, E. Ofek, I Don’t “Recall”: The Decision to Delay Innovation Launch to Avoid Costly Product Failure, SSRN working paper 3492105, November 2019. https://ssrn.com/abstract=3492105 — published in Management Science, 2022. https://doi.org/10.1287/mnsc.2022.4303
- A. Shaked, J. Sutton, Relaxing Price Competition Through Product Differentiation, Review of Economic Studies 49(1), 1982. https://doi.org/10.2307/2297136
- J. Tirole, The Theory of Industrial Organization, MIT Press, 1988.