Income inequality, neighbourhood effects and product quality

In this paper we analyze the effect of income inequality on market outcome and hence the welfare of the consumer in the industry which is both horizontally and vertically differentiated. The idea is that any income distribution over the spatial horizon is reflected in the demand structure and this shapes the market outcome. We consider a setting where the rich and poor live side by side on a linear city and two duopolist firms are positioned at the two ends of the city. We find that for a homogenous distribution of income or when the poor's income or density is too low, both firms offer the same quality. For a homogenous income distribution firm does not perceive much benefit from product differentiation. Given this, for a very high difference in the fixed costs, both firms offer the low quality. But when the difference in the fixed costs is low, both firms offer the high quality. For a more heterogeneous income distribution and an intermediate range of the difference in fixed costs, one firm offers the high quality and the other the low quality. Product differentiation on one hand allows firm to alleviate price competition and, on the other hand, serves consumers' demand better. We show that although in general a rise in income inequality has a spiraling negative effect on the welfare of the poor, there are situations, particularly when the poor income is very low, when an increase in the rich income could be welfare improving for the poor.