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Are ÒinnocuousÓ Minimum Quality Standards really innocuous?

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note.dvi Are ”innocuous” Minimum Quality Standards really innocuous? Paolo G. Garella University of Bologna 14 July 2004 Abstract The present note shows that ”innocuous” Minimum Quality Standards, namely standards that are below the lowest quality level observed in the market, may have effects on equilibrium outcomes. In particular this is true in a duopoly where one high quality firm invests in R&D to lower its cost of quality improve- ments. A Standard that is below, but close to, the lowest quality observed in the market reduces the incentive to invest by the quality leading firm. JEL: L0, L5 Keywords: Regulation, Minimum Quality Standards, Oligopoly, Product Dif- ferentiation, R&D 1. Introduction The role of Minimum Quality Standards (MQS) as a regulatory instrument has re- ceived so far little attention in the theory of oligopoly competition. Starting with Ronnen (1991), however, a small number of papers (see, for instance, Crampes and Hollander 1995, Scarpa 1998) have analyzed the effects of MQS in situations where firms produce, before the introduction of the standard, different qualities of a prod- uct. Then, usually, the analysis is confined to standards that lie between the lowest and the highest quality in the market and that force low quality firms to a higher quality. The models in the literature almost always build upon the vertical differenti- ation models of Gabszewicz and Thisse (1979) and Shaked and Sutton (1981) So far, in no place in the literature, has even been mentioned the possibility that standards that lie below the lowest quality in the market may have any impact on the industry outcome. In what follows I shall term these standards as ”innocuous standards”, due to their unintrusive appearance, although indeed I shall show precisely that they may not be innocuous at all. In particular, in a duopoly, if the leading firm is assumed to be able to invest resources in cost reducing technologies, then an innocuous MQS may lead to lower investment of this so

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