Exogenous Expenses in Industries with Vertical Product Differentiation and Quality Constraints

In this paper we study how an exogenous expense of owning a market good affects the equilibrium outcome in a market with vertical product differentiation i.e. consumers differ by income but have identical preferences for the good’s quality. We identify three possible subgame-perfect equilibrium outcomes dependent on the amount of the exogenous expense. First, at a small exogenous expense tending to zero, quality choice is characterized by maximal product differentiation and all consumers buy one of the two qualities in the market. Second, at a medium exogenous expense, some low-income consumers refrain from buying which incentivizes the producer of the low-quality good to minimize its difference from the high-quality good. In turn, it chooses the best quality from its individually constrained set of quality choices. Third, at a large exogenous expense at which the consumers of the low-quality good cannot afford it, the market is monopolized by the high-quality firm.