Endogenous Quality and Exchange Rate Pass-Through

Abstract

This paper uses a uniquely granular online retail dataset that spans Russia's enormous currency depreciation in late 2014 to show that firms choose to offer lower quality products in response to rising input costs. We show that this reallocation is not driven by an income shock or flight from quality. To explain quality downgrading, we construct a model of demand and firm dynamics where consumers value low prices and high qualities, and firms draw product cost and quality from a joint distribution on entry. We argue that a positive correlation between marginal cost and quality can explain quality downgrading. After verifying this correlation in the data, we calibrate the model and simulate a counterfactual cost shock. The model is able to generate a reallocation in offerings towards low cost, low quality products, and yields starkly different welfare implications following an exchange rate shock than a model with only cost heterogeneity.