A monopolist regulated via a price cap may well have an incentive to change other variables of interest to consumers, in an attempt to shift the cost and demand curves in his favour. This paper develops a model in which the monopolist can vary product quality and the terms of a warranty, in response to price regulation. The regulated and unregulated monopoly outcomes are compared with the Pareto-efficient outcome.

Donald A R George

English

Research Papers in Economics

1
Product Quality Under Regulated Product Quality Under Regulated
Monopoly Monopoly
Donald A R George
Dept. of Economics, University of Edinburgh
21 December 1998
Abstract. A monopolist regulated via a price cap may well have an incentive to change
other variables of interest to consumers, in an attempt to shift the cost and demand
curves in his favour. This paper develops a model in which the monopolist can vary
product quality and the terms of a warranty, in response to price regulation. The
regulated and unregulated monopoly outcomes are compared with the Pareto-efficient
outcome.
Acknowledgements. Precursors of this paper have been presented in seminars at the
University of Edinburgh, Stirling University, Queen’s University (Belfast), University of
East London, Kingston University, Staffordshire University, University of Melbourne
(Australia), University of Waikato (New Zealand), University of Canterbury (New
Zealand), Hamilton College/Colgate University joint seminar (USA) and Queen’s
University (Canada). I am grateful for the invitations to those seminars, and for the
constructive comments made. I am particularly indebted to John Hardman Moore and
Simon Clark. I am also grateful to the Travel and Research Committee of the Faculty
of Social Sciences, University of Edinburgh for a grant. The usual disclaimer applies.2
1. Introduction
It is frequently argued that monopolies may safely be left in the private sector, or
transferred to it, provided they are properly regulated. The well-known welfare losses
due to monopoly, it is said, can easily be mitigated by effective regulation (see
Sappington and Stiglitz, 1987 for a review of these arguments). Thus the dramatic
outbreak of privatisation in the British economy during the 1980’s and 1990’s was
accompanied by the emergence of a new breed of regulator: OFTEL, OFFER,
OFGAS, OFWAT etc.. Regulation typically takes the form of price ceilings imposed
by the regulator on the monopoly, a type of constraint which naturally generates a
great deal of noisy complaint from the monopolist. However the regulator generally
has sufficiently draconian penalties available to impose her will in the end. One would
expect therefore that the rational, profit-maximising monopolist would respond to
binding price control by changing other variables, in an attempt to shift the demand and
cost curves in his favour. Obvious candidates for this role are (a) product quality and
(b) the contractual terms on which the product is offered to the market; for example
the terms of any warranty which the monopolist may provide along with the good.
In order to analyse this problem it is necessary to develop a model which allows the
firm to determine product quality and the terms of any warranty, as part of its overall
(expected) profit-maximising decision. Unfortunately the existing literature does not
provide much of a guide on these matters (though see George, 1996; Mikami, 1991;
Besanko et. al., 1988; Kihlstrom and Levhari, 1977; and Spence, 1975 for related
discussions). Rob (1994) considers the supply of electricity by a private monopoly,
showing that a pure price cap induces the firm to reduce reliability.
In the management literature "product quality" is defined extremely broadly. The term
has been used to refer to safety, availability, maintainability, reliability and usability
(see e.g. Besterfield, 1986). Generally speaking quality is best thought of as a3
characteristic of the product with the property that all consumers prefer more of it to
less, at a given price.  Some such characteristics will be known to the consumer
before purchase, while others will not. For personal computers, for example, the
former type of characteristic might include the size of the processor chip, speed of the
processor chip (200Mhz., 266Mhz., 300Mhz. etc.) or amount of RAM, while the latter
type might include product lifetime, repair costs etc.. Most goods have characteristics
of both types, though the second notion of quality raises more interesting questions for
firms, consumers, regulators and for economic theory. It is the notion of quality dealt
with in this paper.
Firms devote considerable resources to influencing the quality of their products. This
influence operates at the level of product design, production process and post-
production quality control. The unity of the quality management process is often
stressed in the management literature. The distinction between production and quality
control decisions is frequently blurred. For example, a firm may seek to raise its
production quality by, in effect, demanding tighter quality control from its components
suppliers. Thus a production decision in one firm is inseparable from a post-production
quality control decision in another. The model developed in this paper incorporates
production, quality control, warranty and pricing decisions into the firm's overall
(expected) profit maximising behaviour. Product design decisions are not considered.
In the model presented here “quality” will be defined as a kind of “durability”; more
precisely as “the probability of the product not breaking down during a particular time
period (the warranty period)”. This warranty period will, for the sake of tractability be
treated as exogenous. Both firms and consumers will be assumed to be ignorant at the
moment of purchase, as to the quality of any given product, though they will be
assumed to know the average quality of output. Thus the model is one of imperfect
but symmetric information. It will further be assumed that the firm, though just as4
ignorant as consumers, is less risk-averse. This assumption is readily justified, for
example, in the consumer durables market, where each consumer typically owns one
example of the good and is thus extremely concerned at the prospect of its breaking
down. The firm, by contrast, supplies many examples of the good, and may well find it
profitable to operate a risk-pooling warranty scheme. Under these assumptions there
arises a demand, on the part of consumers, for insurance. This might, as mentioned
above, be provided in the form of a product warranty offered by the firm, or an
insurance policy provided jointly with the product. In the case of intermediate goods
"consumers" may be thought of as firms and "warranties" as compensation clauses
built into standard supply contracts. The model is applicable to any situation where the
firm can offer to compensate consumers in the event of a product failure or service
failure, (e.g. train arriving late, telephone connection breaking down). It could readily
be modified to cover partial as well as total failure, or to cover product hazard and
safety issues. Obvious applications are to consumer durables, new vehicles, some used
vehicles (e.g. supplied under dealer “approved used car schemes”), new houses,
privatised rail companies, privatised utilities and a variety of intermediate goods such
as silicon chips and other components whose quality can be assessed independently of
the final product.
Heal (1977) develops a model, involving warranties, which adopts precisely the
informational assumptions discussed above. He remarks:
"Typically the quality control is sufficiently imperfect that no one (i.e. neither seller nor
buyer) will know in advance of  (a product's) use what (its) quality will be, and
consequently some form of guarantee will be offered."  (Remarks in brackets added)
In Heal's model the firm is assumed to produce a probability distribution of qualities
which is simply taken as given. He does not seek to model the process by which the
firm attempts to alter that distribution. In this paper the firm will be assumed able to5
influence the average quality of its output, for example by quality control decisions. It
will also be assumed able to offer a product warranty to the market.
A standard problem, often assumed away, in the literature on quality, is that of moral
hazard on the part of consumers. If consumers can themselves influence the probability
or size of a claim under the warranty, for example by failing to take proper care of the
good during consumption, then the economic role of warranties may be reduced. See,
for example McKean (1970), Oi (1973) and Priest (1981). Goering (1997) discusses
the problem of moral hazard facing a durable goods monopolist.  For simplicity moral
hazard will be assumed away in this paper.
Warranties, whether voluntary or legally compelled, have an important bearing on
quality management decisions because the higher the quality of a firm's  marketed
output, the lower the likely warranty costs experienced by the firm. Thus warranties
provide the firm with an incentive to market high quality products. This connection
between warranties and quality management has been apparent to managers for some
time. Wright (1980), for example, describes events at General Motors:
"I instituted a programme for testing and repairing faulty cars as they came off the
assembly line - and the results were phenomenal.  It cost about $8 a car, which drove
The Fourteenth Floor up the wall.  But I figured one way or the other we would end
up fixing the defects or paying to have them fixed through recall campaigns or dealer
warranty bills........  The internal quality control audit revealed a 66% improvement in
the quality of a Chevrolet coming off the assembly line between 1969 and 1973
models.  And most important, warranty costs of our new cars were down
substantially."
The existing economics literature deals with both the notions of quality discussed
above. When quality is known to consumers before purchase, the focus of interest is6
screening. The seller will be ignorant as to the preferences of any individual consumer
though he may be assumed to know the distribution of preferences across the
population. His problem then is to provide a price-quality schedule, perhaps along with
a warranty arrangement, to the market with a view to screening consumers and thus
extracting the maximum surplus from them. The firm deliberately differentiates his
product by quality. An obvious example is personal computers: most manufacturers
produce a range of products involving different processing speeds, amount of RAM,
size of hard disc etc. This situation merely enlarges the regulator’s problem: she is, in
effect, dealing with a multi-product instead of a single product monopolist. Authors
who develop screening models of quality include Mussa and Rosen (1978) and
Matthews and Moore (1987).
Signalling models, by contrast deal with a different asymmetry of information, namely
one concerning the product itself. Such models are driven by exogenous "type
uncertainty". That is to say "Nature" dictates a firm's quality which is then known to
that firm but not to consumers. The firms problem then is to signal its quality to
consumers using price, warranties and possibly advertising. In a repeat purchase
framework the firm may be able to build up a "reputation" for quality. Authors who
develop signalling models of quality include Grossman (1981), Milgrom and Roberts
(1982, 1986), Kreps and Wilson (1982), Klein and Leffler (1981), Shapiro (1983) and
McClure and Spector (1991). Landon and Smith (1997) develop an empirical model of
quality and reputation indicators, and apply it to the market for Bordeaux wine.
This paper is concerned with product quality that is unknown to the consumer before
purchase since it is product quality in this sense which raises the greater problem for
regulators. Screening models are of no help because they do not deal with this notion
of quality. Signalling models, by contrast, do analyse this concept of quality, but they
do so in a way which treats quality as exogenous and not affected by the firm's
decisions. Again this is of little help in dealing with the regulator’s problem as set out16
efficiently. An effective price ceiling induces the monopolist to worsen the warranty
terms, generating under-insurance and an inefficient allocation of risk. The cost savings
arising from quality reduction and under-insurance are partly passed on to consumers
via the lower price and partly taken by the monopolist as (supernormal) profits.
The model could be extended to analyse other problems, outside the area of regulation.
For example a firm which has joined a cartel may have to agree to restrict output. If
such a firm can vary average product quality and the terms of a product warranty, it is
likely to do so in pursuit of profits.24
Finally we establish:
Proposition 7.  Average quality is lower under regulation than under unregulated
monoply.
Proof. Combining Lemma 5, (A10) and (A14) yields:
¢ C Q
r ( ) <  f z
r ( ) <  f z C Q
m m ( ) ( ) = ¢
(A23)
(Noting that  ¢ f (.) < 0 and  ¢ C (.) > 0)
Hence:     Q
r < Q
m  as required.
References
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Jackson272829

The Multiproduct Firm, Quality Choice and Regulation,

Product Quality Under Regulated Monopoly

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Product Quality Under Regulated Monopoly

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