When Is Distorting Quality More Profitable

Earlier models of quality differentiation showed that the qualities, of differentiated products, were lowered below efficient levels. Recently, qualities were shown to be enhanced, not degraded, in some cases. This paper presents a complete characterization of quality choices under vertical product differentiation by incorporating and refining assumptions on consumer preferences and production technology. This paper shows that the decision to distort quality depends on where the firm's competition quality is located: quality is degraded below (enhanced above) the efficient level when the reservation (or competition) quality is lower (higher) than efficient qualities which are the levels of quality observed in a competitive market (i.e. where marginal willingness to pay equals marginal cost). If the reservation quality is between the two efficient qualities, there is no quality distortion. In competitive markets, the reservation quality is the quality of a substitute good offered by competitors, and thus quality distortion is always present if a multi-product firm competes only at the fringes of its product range. If the competition is in the middle, the firm loses any leverage to distort quality and increase profits. Introducing many levels of quality may be motivated by the desire to fill the gaps in the quality spectrum to maximize control over the quality space. This paper confirms the assertion that the quality distortion occurs at the quality level whose per unit profit margin is lower. However, the claim that a discriminating monopolist tends to enlarge the spectrum of qualities is shown to be valid only if we evaluate the firm's choices apart from the reservation quality or a substitute good. It is proved that the monopolist's quality choices always lie within the interval bounded by efficient qualities and the competition, which should be the relevant quality range. There is no evidence of enlarging quality spectrum arbitrarily even under a monopoly. This paper also provides an example where a merger or a take-over can relax profit constraints.