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Optimal Experimentation in a Changing Environment

(by Sven Rady, with Godfrey Keller)


Review of Economic Studies 66(3), July 1999, pp. 475-507

An earlier version of the paper, containing all technical results and proofs, was circulated as Stanford GSB Research Paper No. 1443 and STICERD Discussion Paper No. TE/97/333.

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This paper studies optimal experimentation by a monopolist who faces an unknown demand curve subject to random changes, and who maximises profits over an infinite horizon in continuous time. We show that there are two qualitatively very different regimes, determined by the discount rate and the intensities of demand curve switching, and the dependence of the optimal policy on these parameters is discontinuous. One regime is characterised by extreme experimentation and good tracking of the prevailing demand curve, the other by moderate experimentation and poor tracking. Moreover, in the latter regime the agent eventually becomes 'trapped' into taking actions in a strict subset of the feasible set.

Keywords: Bayesian Learning, Optimal Control, Monopoly Experimentation
JEL Classification: D83, C61, D42

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