Quality variations in the circular model of variety-differentiated products

Abstract

Quality variations are introduced in the circular model of differentiated products. Two main game structures are analyzed. The three-stage game has entry in the first stage, location in the second, and quality and price choice in the third. The four-stage game replaces the quality and price subgame of the three-stage game with two stages, quality choice followed by price choice. It is found that precommitment in quality (in the four-stage game) allows firms to support the same prices (as in the no-precommitment three-stage game) with lower quality levels and expenditure. This induces entry so that, at the free entry equilibrium, quality is lower and there is a larger number of brands in the precommitment game. In relation to optimality, both games result in higher diversity and under-provision of quality with bigger divergence from optimality observed in the four-stage precommitment game. Compared with a market without competition in quality, the equilibria with quality competition may result in a lower total surplus. A basic inverse relationship is established between the level of quality and the number of varieties at equilibrium. Thus, the establishment of minimum quality standards can reduce the number of varieties and increase total surplus.