nous heterogeneity along lines similar to ours here. The first literature that
comes to mind is concerned with product differentiation. In a myriad of two-
stage games where each firm chooses a quality level or a horizontal characteristic
in the first stage, and then a price for its product in the second stage, endoge-
nous heterogeneity naturally emerges out of the firms’ perception that identical
choices in the first stage will lead to zero profits in the second stage Bertrand
competition due to the resulting homogeneity of the products. See in particular
Gabszewics and Thisse (1979), Shaked and Sutton (1982) for vertical product
differentiation and Tabuchi and Thisse (1995) for horizontal product differen-
tiation with a non uniform density. The present paper will direcly generalize
Motta (1993) and Aoki and Prusa (1996).
The second, extensive literature deals with infinite-horizon industry dynam-
ics allowing for entry and exit. One class of models, exemplified by Jovanovic
(1982), postulates perfectly competitive firms for which differences emerge due
to exogenous idiosyncratic technology shocks. Another class is formed by studies
that do generate endogenous heterogeneity in long run dynamics by considering
firms that invest in capacity expansion (e.g. Besanko and Doraszelski, 2002)
or R&D (e.g. Doraszelski and Satterthwaite, 2004). Simpler two-stage models
with similar flavor but without entry and exit also generate endogenous differ-
ences amongst competing firms: Reynolds and Wilson (2000) and Maggi (1996)
for capacity expansion and Amir and Wooders (1999, 2000) for R&D.
There are several other studies in various areas of industrial organization
where endogenous heterogeneity emerges in a strategic setting. Hermalin (1994)
deals with a two-stage game where firms’ choices of managerial structures take
place before market competition. Mills (1996) and Amir (2000) deal with R&D
games giving rise to equilibrium outcomes with maximal heterogeneity only, i.e.
full R&D by one firm and no R&D by the rival.3 In public economics Mintz
3 Another strand of literature, not directly related to our setting, deals with endogenous
heterogeneity arising out of hybrid models of joint ventures where firms make a cooperative
decision in the first stage followed by product market competition in the second stage: See
e.g. Salant and Shaffer (1998,1999) and Long and Soubeyran (2001).