Optimal Policy for Product R&D with Endogenous Quality Ordering: Asymmetric Duopoly

We examine the optimal R&D subsidy/tax policy under a vertically differentiated duopoly. In a significant departure from the existing work, we consider the case of asymmetric costs of product R&D where there is a small technology gap between firms. In our analysis, the endogeneity of quality ordering is explicitly taken into account. We show that the optimal policy is described by a firm-specific subsidy schedule that is contingent on firms' quality choices. The subsidy schedule not only corrects the distortion in product quality but also selects the socially preferred equilibrium. Both Bertrand and Cournot cases are analyzed.