Working Paper: CEPR ID: DP1793
Authors: Stefan Lutz; Thomas P. Lyon; John W. Maxwell
Abstract: 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.
Keywords: Environment; Product Differentiation; Quality; Regulation
JEL Codes: L13; L15; L51; O28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| minimum quality standards (L15) | increase in product quality of high-quality firms (L15) |
| minimum quality standards (L15) | increase in product quality of low-quality firms (L15) |
| increase in product quality of high-quality firms (L15) | decrease in prices (E31) |
| increase in product quality of low-quality firms (L15) | decrease in prices (E31) |
| decrease in prices (E31) | increase in quantities sold (L11) |
| increase in quantities sold (L11) | increase in total welfare (D69) |
| minimum quality standards (L15) | decrease in industry profits (L16) |
| high-quality firm pre-commitment to quality level (L15) | manipulate regulator for weaker standards (L51) |
| manipulate regulator for weaker standards (L51) | decrease in overall welfare (D69) |