Price Regulation and Quality of Service

Public concern has been rising about whether market forces are sufficient to ensure the optimal choice of quality of services. We examine a model in which unregulated competition leads to an underprovision of quality from a social perspective and then study the effects of price regulation. Although price floors sometimes have the expected effect of increasing the incentives to raise the quality of services, their imposition changes the nature of competitive behaviour in subtle ways and often changes the relative positions of firms in the market. We show that no price floor exists which will achieve the socially optimal quality choice and the only price floors that result in symmetric firm behaviour are those which involving an overinvestment in quality. We also examine the effects of imperfect consumer information about quality under various consumer learning processes and find that slow but plausible learning behavior can lead to an increase in quality. We also show that firms typically benefit from consumers' uncertainty about the quality of both their own good and their rival's. Informative advertising about the firm's or its rival's product is not in the firm's best interest.