Cost Reduction can Decrease Pro t and Welfare in a Monopoly

This paper develops a monopoly model in which two vertically differentiated goods are supplied and involve a within-product network externality. Within this model, I examine how the cost of the high-quality good affects the firm’s profit and welfare, demonstrating a surprising result that both the profit and welfare are U-shaped in the cost and thus, in particular, a decrease in the marginal cost can reduce the monopoly profit. I show that the assumptions of the fulfilled expectations equilibrium and multi-product monopoly lead to this counter intuitive possibility. Furthermore, changes in production costs and in quality yield cannibalization such that the consumption of one good increases while that of the other decreases.