How Does Income Inequality Affect Market Outcomes in Vertically Differentiated Markets?

Abstract

The distribution of consumer incomes is a key factor in determining the structure of a vertically differentiated industry when consumer's willingness to pay depends on his income. This paper computes the Shaked and Sutton (1982) model for a general specification of consumers' income distribution to investigate the effect of inequality on firms' entry, product quality, and pricing decisions. The main findings are that greater inequality in consumer incomes leads to the entry of more firms and results in more intense quality competition among the entrants. This is due to the elasticity of consumer demand for quality being higher in more inegalitarian economies. More intense quality competition among firms causes them to locate their products in higher ranges of the quality spectrum, closer to each other, decreasing the degree of product differentiation. Competition between more similar products tends to reduce their prices. However, when income inequality is very high, the top quality producer chooses to serve only the rich segment of the market, and the low price elasticity of demand of these consumers allows him to charge a higher price. The conclusion is that income inequality has important implications for the degree of product differentiation, price level, industry concentration, and consumer welfare.