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Bundling and Endogenous Product Differentiation

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This paper follows the model setting of Martin (1999) and Lin and Saggi (2002) to construct a three-stage game model of two-firm, two-type products. We further takes into account product innovation competition in competing good market, in order to consider the bundling effects on product innovation, firms¡¦ profit, consumer surplus, and welfare. We find that Bundling increases both firms¡¦ product innovations when the degree of product differentiation of competing good is lower than an approximation of one-half. Instead, when the degree of substitutability of competing good is larger than the critical value the bundling still increase rival firm¡¦s product innovation but decreases its own product innovation level. If the initial value of degree of product differentiation is greater than 0.5, then bundling is the dominant strategy for firm A. When both firms engage product innovation competition, bundling may increase the

rival¡¦s profit and welfare, and increases consumer surplus.