Capacity Choice under Uncertainty with Product Differentiation

We explore the characteristics of a capacity-then-price game for a duopoly market with product differentiation and stochastic demand. The analysis shows that a minimum threshold value for the level of vertical product differentiation exists, relative to horizontal product differentiation, for which existence of a Nash equilibrium in pure strategies is guaranteed. We find that when the quality and cost differences between the firms exactly offset each other, demand uncertainty causes equilibrium outcomes in capacities to become asymmetric. Without demand uncertainty, only a symmetric equilibrium can be established. This difference between stochastic and deterministic demand is the main driver behind our finding that if the regulator ignores the stochastic nature of demand, regulation lowers welfare for a large range of parameters, that is for approximately 10 per cent of the plausible parameter space.