How does firms’ cost structure affect their quality–price mix? An experimental analysis

Abstract

Experimental literature on product differentiation is scarce and mostly focused on horizontal product differentiation. This paper focuses on vertical product differentiation considering a quality-then-pricing duopoly game and exploring how firms’ cost structure affects firms’ decisions and market structure. Two scenarios are considered, differing in the way quality affects production costs: in the first, quality is costless, while, in the second, marginal production costs increase with quality. We explore the impacts on market coverage, qualities, product differentiation, prices, and intensity of competition (assessed by price-cost margins). Our experimental results confirm the (theoretically proved) need to endogenize the market structure, as a duopoly with full coverage emerges when quality is costless, but a duopoly with partial coverage emerges when quality is costly. We also find that quality differentiation is lower in the lab than what is theoretically predicted, and lower in the costless quality treatment. The intensity of competition is higher when quality is costly, as price-cost margins are lower in this case.