Quality Choice:

In the example with used cars, it was assumed that car producers did not deliberately produced cars with varying qualities; more and less random factors in the production process was assumed to produce a proportion, q, of cars of high quality, and 1−q, of low quality. However, producers may in general be tempted to produce widgets of low or high quality, if it is less costly to produce a low quality widget. First we will assume that the cost of production is the same though, and we’ll ask what happens on the market in this case.

We assume the same numerical values as before (but it is not cars we talk about now); but consumers cannot distinguish high from low quality widgets so their reservation price reflects the expected quality: " Pbuy = q .120 + (1−q) . 70. Let’s assume that it costs 100kr to produce a widget (irrespective of quality). There are now three different cases to consider: i) If the producers choose to manufacture only low quality widgets; q = 0, and " ‾P_buy = 70kr, but in this case the price is below the average cost of production, and no widgets are sold; ii) if only high-quality widgets are sold "‾P_buy = 120kr, but with perfect competition the equilibrium price will be lowered down to P^∗ = 100kr, this is good for the consumers who gets a surplus of 20kr per unit bought; iii) if both high- and low-quality widgets are manufactured, the proportion of high-quality widgets must be at least q^∗ = 3/5 ; if it’s lower the buyers’ reservation price drops below the average cost of production and no widgets are supplied.

Finally, let’s make the reasonable assumption that it cost less to produce low- than high-quality widgets. The producers’ reservation price is now their average costs, or ‾P_H = 100kr and. ‾P_L = 80kr, we assume. If you were a producer of widgets and the market is characterized by perfect competition, how would you choose quality? Let’s assume that the market price is P = 100; if you choose to supply a high-quality widget, your profit will be equal to zero, but it will be 20kr per unit if you produce a low-quality widget. Since it’s a competitive market, you assume that you can do this without affecting the market price. The hitch is, though, that all producers think the same way and all manufacture widgets of low quality; the market price must therefore drop to ‾P_L = 80kr, but this is still higher than the buyers’ reservation price for low-quality widgets so nothing will be produced or sold.

The example illustrates a complete market failure, since the buyers’ reservation price for high-quality widgets is 120kr and the average cost of production is 100kr. The establishment of high-quality production of widgets is Pareto-efficient, but it will not occur due to the possibility of low-quality production, and the difficulty (impossibility) of consumers to distinguish high- from low-quality widgets.

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