Expectations of Bailout and Collective Moral Hazard

We analyze an infinite horizon stochastic game with discounting of future single period payoffs that models interaction between Cournot duopolists producing differentiated products. There are two states of demand for an output of each firm. The probabilities of their occurrence depend on random factors and on investing or not investing into product innovation. If the low state of demand occurs for an output of each firm, then the government not observing firms’ investments into product innovation bails out each firm with a positive output. A weakly renegotiation-proof perfect public equilibrium is the solution concept that we apply. It is a perfect public equilibrium in which no two replaceable continuation equilibrium payoff vectors are strictly Pareto ranked. Taking into account expected bailout, there exists a weakly renegotiationproof perfect public equilibrium with a strictly Pareto efficient equilibrium payoff vector, in which, along the equilibrium path, the firms collude on not investing int o product innovation.