We investigate a mixed duopoly, where a state-owned welfare-maximizing public firm competes against a profit-maximizing private firm. We use a Hotelling-type spatial model which represents product differentiation. We endogenize production costs by introducing cost-reducing activities We show that the private firm's cost becomes lower than the public firm's because the private firm engages in excessive strategic cost-reducing activities. Even though each firm's cost is heterogeneous, the locations ofthe firms are socially efficient, given the cost differentials. Privatization of the public firm would improve welfare because it would mitigate the loss arising from excessive cost-reducing investments.
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