1. Monopoly and Quality Welfare analysis

2. Quality, profits and welfare Higher quality is valued by consumers How much of this extra surplus can the monopolist extract? If not all, monopoly may under-provide quality Surprisingly, the opposite could also happen: over-provision Illustrate basic ideas with examples.

3. Example 1. Quality too low High Quality Low Quality h31 m21 l11 Sell L quality: p=1, profits =3 Sell H quality: p=2, profits = 4 Consumer surplus: 0 in first case, 1 in second case. Welfare change = 2 – extra cost Change in profits = 1 – extra cost If 1<extra cost<2, monopolist will choose L which is socially inefficient Key property: Quality increases consumer heterogeneity

4. Example 2. Quality too high High quality Low quality h33 l32 Low quality  p=2, profits=4 High quality  p=3, profits=6 Increase in total surplus = 1 – extra cost Increase in profits = 2 – extra cost If 1< extra cost < 2, monopoly chooses H and socially optimal is L. Key property: quality makes market more homogeneous  useful as an instrument to extract consumer surplus.

5. Example 3. Welfare Gain > increase in profits q pLpL pHpH Increase in profits = q x (p H – p L ) Increase in surplus > q x (p H – p L ) Quality valued more by consumers with high reservation values Quality makes consumers more heterogeneous (increases spread in reservation values)

6. Example 4. Welfare gain > increase in profits qLqL pLpL p H = Example: p L =1-q p H =1-q/a, a >1  L =1/4, CS L =1/8  H = ¼ a, CS H = 1/8 a Increase in surplus = 3/8 (a-1) Increase in profits = ¼ (a-1) q H = aq L Quality valued more by consumers with low reservation values – market expands

7. Example 5. Welfare gain < increase in profits q pLpL pHpH Quality valued more by consumers with low reservation values – no change in quantity Increase in profits = q x (p H – p L ) Increase in surplus < q x (p H – p L ) Quality makes consumers more homogeneous (reduces spread in reservation values)

8. Conclusions Quality increases consumer surplus Monopoly may under-provide when it cannot appropriate all the extra CS  Very likely when quality increases heterogeneity  Could also occur when quality increases total sales Monopoly may over-provide, when quality reduces heterogeneity: value as an instrument to extract CS