Optimal pricing and quality choice of a monopolist under Knightian uncertainty

This paper analyzes a simple vertical product differentiation model with demand uncertainty and derives a risk neutral monopolist's optimal market entry timing, her optimal pricing and optimal quality choice by incorporating Knightian uncertainty, irreversibility, and flexibility in quality-enhancing investment into a continuous-time stochastic model. It is shown that an increase in Knightian uncertainty induces decreases in the optimal price, the optimal quality, and the value of undertaking the quality-enhancing investment by the monopolist. The social optimal entry timing, pricing and quality are also analyzed.

Research highlights► We model the quality choice of a monopolist under Knightian demand uncertainty. ► We examine effects of Knightian uncertainty on a risk neutral monopolist's behavior. ► Increasing Knightian uncertainty decreases the optimal price and the optimal quality. ► Increasing uncertainty decreases the value of the quality-enhancing investment.