This paper develops a model of vertical differentiation in the Internet search engine market. A key property of the model is that users who try out one engine may be dissatisfied with the results, and consult another engine in the same session. This residual demand allows lower quality engines to survive in the equilibrium. We consider a two-period game between an incumbent and an entrant who enters in the second period. Since users prefer to try out a higher quality engine first, the demand for an engine is discontinuous in quality, depending on whether the engine has high or low quality. We take into account brand loyalty for the incumbent. The interaction of brand loyalty and a cost advantage for the entrant determines which engine has higher quality in equilibrium.
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