1. The Keith-Leffler Model
Managerial Economics-Charles W. Upton

2. The Keith Leffler Model
The Problem
Suppose it costs $10 to make a high quality product. Competition will force the price to $10. Hence
If you can make a low quality product for $5 and pass if off you can make money until caught.
But there is no reward for making a high quality product.
The Keith Leffler Model

3. The Keith Leffler Model
Assumptions
Two levels of quality, qhigh and qmin.
The Keith Leffler Model

4. The Keith Leffler Model
Assumptions
Two levels of quality, qhigh and qmin.
Higher quality products cost more to produce.
The cost function is
C(X,qhigh) or
C(X,qmin).
The Keith Leffler Model

5. The Keith Leffler Model
More Assumptions
The public cannot tell in advance whether a firm produces a high quality or a low quality product, but can after a year.
The Keith Leffler Model

6. The Keith Leffler Model
More Assumptions
The public cannot tell in advance whether a firm produces a high quality or a low quality product, but can after a year.
Consumers know - don’t ask how - the minimum cost of producing both qhigh and qmin.
The Keith Leffler Model

7. Produce High or Low Quality?
AC(X,qmin)
MC(X,qmin)
The Keith Leffler Model

8. Produce High or Low Quality?
MC(X,qhigh)
AC(X,qhigh)
AC(X,qmin)
MC(X,qmin)
The Keith Leffler Model

9. The Keith Leffler Model
Three Strategies
Be honest. Produce a low quality product and sell it at the low price.
Be honest. Produce a high quality product and sell it at the high price.
The Keith Leffler Model

10. The Keith Leffler Model
Three Strategies
Be honest. Produce a low quality product and sell it at the low price.
Be honest. Produce a high quality product and sell it at the high price.
Cheat. Produce a low quality product, label it a high quality product and sell for a year at the high price.
The Keith Leffler Model

11. The Keith Leffler Model
Profits
Be honest. Produce a low quality product and sell it at the low price.  = 0
Be honest. Produce a high quality product and sell it a the high price.  = 0
Cheat. Produce a low quality product, label it a high quality product and sell for a year at the high price. Let’s see
The Keith Leffler Model

12. Produce High or Low Quality?
MC(X,qhigh)
AC(X,qhigh)
AC(X,qmin)
MC(X,qmin)
The Keith Leffler Model

13. Produce High or Low Quality?
The Keith Leffler Model

14. Produce High or Low Quality?
Optimal production for low quality product P
The Keith Leffler Model

15. Produce High or Low Quality?
Optimal production for low quality product π
The Keith Leffler Model

16. Produce High or Low Quality?
Extra production due to spurious higher price π
The Keith Leffler Model

17. Produce High or Low Quality?
π 2
Extra production due to spurious higher price
π1
The Keith Leffler Model

18. Produce High or Low Quality?
π2
Honesty  =0
Cheating   =(π1+ π2)/(1+r)
π1
The Keith Leffler Model

19. Produce High or Low Quality?
π2
Honesty may be its own reward but not here
π1
The Keith Leffler Model

20. The Incentive for HonestyP*
π2
Now suppose there is a premium for honesty
π1
The Keith Leffler Model

21. The Incentive for HonestyP*
π2
The honest firm produces here
π1
The Keith Leffler Model

22. The Incentive for HonestyP* A
Its profit is the area A
The Keith Leffler Model

23. The Dishonest Firm Does MoreP*
The Keith Leffler Model

24. The Keith Leffler Model
Its Profits P* A D B C
The Keith Leffler Model

25. The Keith Leffler Model
Its Profits P* A D
B+C Profits from cheating B C
The Keith Leffler Model

26. The Keith Leffler Model
Its Profits P* A D
A Profits from the premium for honesty B C
The Keith Leffler Model

27. The Keith Leffler Model
Its Profits P*
D Profits form cheating on the premium for honesty A D B C
The Keith Leffler Model

28. The Keith Leffler Model
The Difference P*
The Cheat earns A +B+C+D once A D B C
The Keith Leffler Model

29. The Keith Leffler Model
The Difference P*
The Cheat earns A +B+C+D once A D
The Honest Firm earns A again and again B C
The Keith Leffler Model

30. The Keith Leffler Model
To Cheat or Not to Cheat P*
The Cheat earns A +B+C+D once A D
The Honest Firm earns A again and again B C
The Keith Leffler Model

31. The Keith Leffler Model
End
©2004 Charles W. Upton
The Keith Leffler Model