The role of market frictions on the price differential: A search-theoretical approach

Abstract

To shed light on how market frictions and the waiting time of imitators affect prices and how effective research subsidy and patent protection affect the price differential, this paper adopts a direct search-theoretical approach to capture the searching behaviors of consumers and producers in the innovative and imitative markets. As a result, this model shows that the price differential with endogenous market frictions would react to the change of quality the least. A shorter durability would result in a wider price differential in the model without the extra state for imitators than in the model with the extra state. While a research subsidy shrinks the price differential, and improve consumers’ flow values, the patent protection widens the price differential, hurts imitators’ profits and may not improve the consumers’ flow values. The innovators could take the advantage of the effects of durability on price differential by inventing products which might influence the durability of the products currently hold by the consumers. This finding might provide an explanation on why the latest versions of computer products are invented less likely convertible to older versions of Windows or associated software.