Quality-based competition, profitability, and variable costs

We consider the impact of variable production costs on competitive behavior in a duopoly where manufacturers compete on quality and price in a two-stage game. In the pricing stage, we make no assumptions regarding these costs – other than that they are positive and increasing in quality – and no assumptions about whether or not the market is covered. In the quality stage, we investigate a broad family of variable cost functions and show how the shape of these functions impacts equilibrium product positions, profits, and market coverage. We find that seemingly slight changes to the cost function's curvature can produce dramatically different equilibrium outcomes, including the degree of quality differentiation, which competitor is more profitable (the one offering higher or lower quality), and the nature of the market itself (covered or uncovered). Our model helps to predict and explain the diversity of outcomes we see in practice – something the previous literature has been unable to do.