Variety and Quality Competition in a Horizontal Differentiation Model: a welfare analysis

This paper analyses decisions on quality and variety in a horizontal differentiation model following Hotelling (1929). Price instability does not occur, when firms recognise their mutual interdependence and respect each other's backyards. This argument is elaborated in the Hotelling scenario. Price stability is also avoided, when limit prices are set. this argument is elaborated in the limit price scenario. In the Hotelling scenario there is a tendency towards minimum differentiation, in the limit price scenario there is neither minimum nor maximum differentiation. In both scenarios the duopolists underinvest in quality improvement, since competition forces them to pass all surplus created to the consumers. Because the duopolists underinvest, both the social planner and the monopolist outperform them in terms of social welfare. Asymmetry in (initial) quality is widened through time: the leading firm invests more in R&D, the lagging firm invests less. Asymmetry is shown to be beneficial for both consumer surplus and industry profits.