Academic journal article Atlantic Economic Journal

Product Reliability, R&D, and Manufacturing Cost Shocks

Academic journal article Atlantic Economic Journal

Product Reliability, R&D, and Manufacturing Cost Shocks

Article excerpt

Introduction

Consider an industry where product failure imposes considerable costs on both the buyer and the seller. A seller who warrantees a product by promising to repair or replace a defective unit incurs the associated costs. The buyer has the costs associated with returning the product. Suppose the firm can do R&D which increases the proportion of products that are judged by customers to be "reliable" in that they are not returned. The key research question of this paper concerns the effects of such R&D for firms with market power under various assumptions about marginal manufacturing costs. Suppose, for example, there is a shock to input prices that increases the marginal manufacturing cost. The firm might respond by increasing its R&D. The resulting improvement in product reliability would then offset some of the increase in the manufacturing costs. On the other hand, the increase in the marginal manufacturing cost may cause quantity produced to fall sufficiently, so that the optimal response is to do less R&D. The primary result is that a manufacturing cost shock prompts the firm to do less R&D in the cases where the replacement cost is low or the marginal manufacturing cost is high. Conversely, if the replacement cost is high and the marginal manufacturing cost is low, then the firm increases R&D, mitigating some of the increase in the manufacturing cost.

The paper also compares the outcomes for reliability, profits, consumer surplus, and social surplus for the optimal R&D case as compared to the case of doing no R&D, paying particular attention to how exogenous changes in the marginal manufacturing cost affect this comparison. The first section considers a monopoly seller in a single market. In that case it will be seen that exogenous increases in the marginal manufacturing cost increase the positive effect of an optimal R&D strategy compared to no R&D for all outcomes except for reliability itself. The second section considers a two-country, two-firm, intra-industry trade model. In the monopoly model R&D increases firm profits. In the duopoly model optimal R&D increases reliability, consumer surplus, and social surplus more than it does in the equivalent monopoly model, but it does not necessarily increase profits. The duopoly R&D game has a prisoner's dilemma type solution. Profits would be higher for both firms if neither does R&D, but profits are even worse if your competitor does R&D and you do not. Equivalently, if you are the only firm to do R&D your profits increase. The effect of an exogenous increase in the marginal manufacturing cost for a symmetric duopoly is analogous to that of a monopoly, except for the effect on profits just mentioned. The duopoly model also allows for the case of country-specific marginal manufacturing cost shocks.

Monopoly models with reliability or quality as the output of R&D are found in Daughety and Reinganum (1995) and Saha (2007). El Ouardighi et al. (2014) is a recent addition to the duopoly literature initiated by d'Aspremont and Jacquemin (1988, 1990) where R&D expenditures cause a reduction in a marginal cost parameter. Ma (2015) presents a monopoly model where R&D increases market size but has no effect on cost. The international flavor of that model is that production may shift from North, where the R&D is done, to South.

Haaland and Kind have a set of papers with an international duopoly model similar to that of the present paper in that R&D increases product quality. In Haaland and Kind (2006) R&D increases customer demand but has no effect on costs, while in Haaland and Kind (2008) R&D does not affect demand but reduces manufacturing cost. In Jinji and Toshimitsu (2006) R&D affects demand but not costs, while in DeCourcy (2005) R&D affects costs but not demand. Both effects of R&D spending are found in Gretz et al. (2009) and Highfill and McAsey (2010). …

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