DP1793 Strategic Quality Choice with Minimum Quality Standards

Author(s): Stefan Lutz , Thomas P Lyon , John W Maxwell

Publication Date: January 1998

Keyword(s): Environment , Product Differentiation , Quality , Regulation

JEL(s): L13 , L15 , L51 , Q28

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP1793.asp

In many markets governments set minimum quality standards while some sellers choose to compete on the basis of quality by exceeding them. Such ‘high-quality’ strategies often win public acclaim, especially when ‘environmental friendliness’ is the dimension along which firms are differentiated. We analyse this phenomenon using a duopoly model of vertical product differentiation. A minimum quality standard leads both the high-quality and the low-quality firm to increase product qualities, lower prices, and increase quantities sold. As a result, total welfare increases. Industry profits fall, however, because reduced quality differentiation intensifies price competition. If the high-quality firm can commit to a quality level before regulations are promulgated, it induces the regulator to weaken its standards, and welfare falls.