Better Product at Same Cost, Lower Sales and Lower Welfare

Abstract

We consider a high-quality dominant firm facing a low-quality competitive fringe. We show that the effect of an increase in the dominant firm's product quality on its equilibrium quantity depends on its marginal cost relative to that of the fringe firms. The dominant firm's output increases in its quality when its cost exceeds that of the fringe, is independent of its quality when marginal costs are equal, and decreases in its quality when the dominant firm's cost is lower than that of the fringe. An increase in the dominant firm's quality does not cause a parallel shift in its residual demand, but rather causes it to pivot. This, in turn, causes its marginal revenue curve to rotate clockwise, rather than shift outwards, at a height that we show to be equal to the fringe firms' cost. This fact, combined with the dominant firm's MR=MC condition, determines the result. For closely related reasons, the effect of a quality increase on consumer welfare also depends on the relationship between the costs. The sign on consumer welfare is ambiguous. It is possible that all consumers are (weakly) better off, that some are better off and some worse off, or that all are (weakly) worse off. We also consider several extensions and variations of the model.