Introduction

In chapters 2 to 4 we were concerned with the type of product differentiation that Lancaster (1979) has termed ‘horizontal’. Its distinguishing property is that, if such products are offered at the same price, consumers, if asked to do so, would rank them differently. Thus, if a number of firms were offering distinct ‘horizontally’ differentiated products at the same price, each would obtain a strictly positive market share. It is in this sense that the equilibrium might be one of product variety.

However, an equally important aspect of product differentiation is quality, the idea that some goods are just of a higher specification than others and that it is this that is the source of their higher valuation. We started the analysis of this in chapter 5 but there, by assumption, a feature of the equilibria was that there was only a single quality on sale. What we want to do in this chapter is to remedy this ‘single-quality’ feature by turning to the analysis of what is termed ‘vertical’ product differentiation.

Products are said to be ‘vertically’ differentiated if, when offered at the same price, all consumers choose to purchase the same one: that of highest quality. Of course, in equilibrium, assuming that consumers differ in their willingness to pay for quality improvement, products will sell at different prices with the higher quality products being sold at a premium over the price of rival lower quality products.