In a vertically differentiated market in which consumers have varying willingness to pay
for quality, firms can relax price competition by differentiating the quality of their products.
Governments may want to regulate quality to reduce the distortion that vertical
differentiation produces on prices and market provision of quality.
Examples of Minimum Quality Standard (MQS) include product safety standards for
manufactured products,1 contents requirements for food and pharmaceuticals, and
environmental standards (following the ongoing debate in Europe on environmental
issues, the European Parliament recently reached an agreement with the European Union
Council of Ministers on the text of a new directive on air quality,2 which will become
effective in 2011).
The model analyzes the effects of the introduction of an MQS in a vertically differentiated
market in which three identical firms play a two-stage quality/quantity game. We assume in particular that firms face quality-dependent fixed costs. In what follows, we refer to the
framework which has been proposed initially by Mussa and Rosen (1978) and analyzed
in detail by Motta (1993). Shaked and Sutton (1982 and 1983) show that under a similar
framework, when quality-dependent costs are only fixed (or at least unit cost for quality
enhancement rise sufficiently slowly with quality), there is an upper bound to the number
of firms that can coexist in the market (finiteness property). |