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If at First You Don't Succeed...: Profits, Prices and Market Structure in a Model of Quality with Unknowable Consumer Heterogeneity

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  • Kala Krishna
  • Tor Winston

Abstract

Why are higher quality niches seen as intrinsically more profitable in business circles? Why do high quality products sometimes have a low real price, while it is unusual to see low quality products with high real prices? Can markets have quality differentiation as well as quality bunching? In this paper we develop a new model of quality which explains such phenomena. Our model builds on the idea that even if a customer chooses to purchase a product, it may fail to deliver'. If a product fails to deliver, the customer may wish to choose some other product. A higher quality product has a higher probability of delivering. We model this as a three stage game where firms first choose whether to enter or not, then in the second stage choose their quality and in the last stage, their price. Our model has a number of interesting predictions. First, it suggests that in equilibrium, a wider range of price per unit of quality is to be found for high quality goods than for low quality ones. Second, it provides a theoretical reason for why high quality niches may be more profitable, supporting the common business school idea that the money is at the high end.' Third, it suggests that the nature of the fixed costs of establishing quality plays a critical role in determining when free entry could be consistent with the existence of profits and result in natural oligopolies' and when it would tend to eliminate all profits.

Suggested Citation

  • Kala Krishna & Tor Winston, 2000. "If at First You Don't Succeed...: Profits, Prices and Market Structure in a Model of Quality with Unknowable Consumer Heterogeneity," NBER Working Papers 7494, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:7494
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    References listed on IDEAS

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    1. Bouckaert, Jan & Degryse, Hans, 2000. "Price competition between an expert and a non-expert," International Journal of Industrial Organization, Elsevier, vol. 18(6), pages 901-923, August.
    2. Swan, Peter L, 1970. "Durability of Consumption Goods," American Economic Review, American Economic Association, vol. 60(5), pages 884-894, December.
    3. Mussa, Michael & Rosen, Sherwin, 1978. "Monopoly and product quality," Journal of Economic Theory, Elsevier, vol. 18(2), pages 301-317, August.
    4. d'Aspremont, C & Gabszewicz, Jean Jaskold & Thisse, J-F, 1979. "On Hotelling's "Stability in Competition"," Econometrica, Econometric Society, vol. 47(5), pages 1145-1150, September.
    5. Weitzman, Martin L, 1979. "Optimal Search for the Best Alternative," Econometrica, Econometric Society, vol. 47(3), pages 641-654, May.
    6. Kala Krishna & Tor Winston, 1998. "A New Model of Quality," NBER Working Papers 6580, National Bureau of Economic Research, Inc.
    7. Sheshinski, Eytan, 1976. "Price, Quality and Quantity Regulation in Monopoly Situations," Economica, London School of Economics and Political Science, vol. 43(17), pages 127-137, May.
    8. Shetty, Y. K., 1987. "Product quality and competitive strategy," Business Horizons, Elsevier, vol. 30(3), pages 46-52.
    9. Shaked, Avner & Sutton, John, 1983. "Natural Oligopolies," Econometrica, Econometric Society, vol. 51(5), pages 1469-1483, September.
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    Cited by:

    1. Alexandre Gaudeul, 2004. "Shareware competition: Selling an experience," Game Theory and Information 0409008, EconWPA.
    2. Dulleck, Uwe & Kerschbamer, Rudolf, 2009. "Experts vs. discounters: Consumer free-riding and experts withholding advice in markets for credence goods," International Journal of Industrial Organization, Elsevier, vol. 27(1), pages 15-23, January.
    3. David Bardey, 2004. "A paradoxical risk aversion effect on the consumers' demand for quality," Recherches économiques de Louvain, De Boeck Université, vol. 70(1), pages 109-115.

    More about this item

    JEL classification:

    • D4 - Microeconomics - - Market Structure, Pricing, and Design
    • D6 - Microeconomics - - Welfare Economics

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