WORKING PAPERS Better Product at Same Cost, Lower Sales and Lower Welfare

We analyze the effect of product quality on the output of a high-quality dominant firm facing a low-quality competitive fringe. Using a standard vertical differentiation model, we show that profit maximizing output decreases with product quality when the dominant firm’s marginal cost is lower than that of the fringe, is independent of quality when marginal cost is the same for all firms, and is increasing in quality when the dominant firm’s marginal cost is higher than that of the fringe. The driving force behind this result is that an increase in product quality does not cause a parallel shift in the dominant firm’s residual demand, but rather causes it to pivot. This, in turn, causes the dominant firm’s marginal revenue curve to rotate, rather than shift outwards, resulting in inwards movement around the equilibrium output when the dominant firm’s marginal cost is lower than the fringe’s. Equally strikingly, higher quality at the original marginal cost may result in all consumers being weakly worse off, with some being strictly worse off. Similar results can be obtained without a competitive fringe, but only under some more restrictive conditions. JEL Classification Codes: L15, L13.