Minimum Quality Standards, Fixed Costs, and Competition

Abstract

I investigate the consequences of imposing a minimum quality standard on an industry in which firms face quality-dependent fixes costs and compete in quality and price. Even though the high-quality sellers would satisfy the standard in the absence of regulation, imposing a standard leads these sellers to raise qualities. They do so in an effort to alleviate the price competition, which intensifies as a result of the low-quality sellers' having raised their qualities to meet the imposed standard. However, by its very nature, a minimum quality standard limits the range in which producers can differentiate qualities. Hence, in the end, price competition intensifies, and prices -- "corrected for quality change" -- fall. Due to the better qualities and lower hedonic prices, and compared to the unregulated equilibrium, all consumers are better off, more consumers participate in the market, and all participating consumers -- including those who would consume qualities in excess of the standard in the absence of regulation -- select higher qualities. When the consumption of high-quality products generates positive externalities -- as in the case of safety products -- these results favor minimum quality standards. I also show that even in the absence of externalities an appropriately chosen standard improves social welfare.