Abstract
This paper studies the effect of non-compliance with a minimum quality standard on prices, quality, and welfare in a vertical differentiation model. Non-compliance with a minimum quality standard by a low-quality firm reduces quality levels of both firms and shifts demand from the low-quality to the high-quality firm. Under non-compliance, an increase in the standard increases the quality of both products and shifts demand from the high-quality product to the low-quality product. Stricter government enforcement decreases the quality level of the low-quality firm and shifts demand from the low-quality firm to the high-quality firm. Non-compliance of the low-quality firm increases profits for both firms, reduces consumer surplus, and increases or decreases welfare depending on the market size, the detection probability, surveillance cost, and the minimum quality level.
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