Prof. Bryan Caplan

Econ 370


Week 8: Markets for Variety and Quality

I.                     Product Variety and Product Quality

A.                 Only recently have researchers begun to fully appreciate the fact that product quality is an important component of consumer welfare.  The computers, cars, food, and other products we buy are better than the computers, cars, and food of the past.  Cox and Alm explore this point in great detail.

B.                 Product variety remains an enormously under-rated component of consumer welfare.  This is most obvious in music and literature, but holds across the spectrum: food, clothes, vacations, etc.  Even though one type of music may not be better than another, it still enhances welfare just by being different.

II.                   Differentiated Competition

A.                 Everything else equal, it is better to have more variety. 

B.                 Why don't we produce all possible varieties?  There must be a fixed cost of introducing additional varieties.

C.                If there is a fixed cost of introducing a variety, and a constant marginal cost of production:

1.                  How many firms will produce each variety?

2.                  If firms face equally efficient potential competitors, how must they set their price?

D.                What happens if:

1.                  Demand for a particular variety is very low (always below AC)?  (It isn't produced at all.)

2.                  Demand for a particular variety is low, but at some point crosses AC?  (It is produced at a high price.)

3.                  Demand for a particular variety is high?  (It is produced at a low price!)

4.                  How do these results change if AC eventually turns up?

E.                 What might this tell you about:

1.                  Pricing at a small local convenience mart.

2.                  Pricing of videos for sale.

3.                  Why your favorite brand went off the market?

F.                 Question: How does population affect the level of variety the market provides?

G.                Answer: More population means that ever more eccentric tastes are profitable to satisfy.  With a small population, you will see "one size fits all" production; with a large population, a product for every type and taste.

III.                  Quality Competition

A.                 Why don't we all consume the highest possible quality?  (Higher quality must cost more). 

B.                 Is it price discrimination, or is it quality competition?  Competitive supply of different quality levels should lead their price difference to equal the difference in their cost of production.

C.                Since more quality costs more, there is always an incentive to cut quality if customers don't notice.  The market mostly solves this problem with:

1.                  Reputation

2.                  Guarantees

D.                Why don't ALL possible quality levels exist?  Different quality levels are a special case of product variety: there must be a fixed cost of supplying more quality levels.

1.                  Why is it better to be poor in a poor country than poor in a rich country?

IV.               Regulation and Quality

A.                 Does it benefit consumers to ban low quality levels?  (Note: Safety is presumably one aspect of quality).  How could it?  This just forces people who want low quality to either buy nothing or pay for more quality that they don't want.

B.                 Applications:

1.                  Airbags.

2.                  FDA.

3.                  Urban renewal.

C.                How do price controls affect product quality?  The quality of surplus products tends to improve; the quality of products in shortage tends to decline.  Ex:

1.                  Shrinking candy bars during Nixon's price controls.

2.                  Deterioration of NYC housing stock.

3.                  Meals on regulated airlines.

D.                Bans of varieties and qualities a form of monopoly privilege to un-banned varieties and qualities.

V.                 Black Markets and Prohibition

A.                 Sometimes certain varieties or qualities of products are banned or "prohibited."  Ex: Narcotics, alcohol, prostitution, gambling, irreligious books.  This constriction of variety reduces consumer welfare.

B.                 Once prohibited, products are often still sold illegally on the "black market." 

C.                One obvious impact of prohibition is to raise the price.  (Why?)  A less obvious impact is to reduce product quality.

D.                Product quality tends to decline because the usual market assurances of quality (reputation, warrantees) don't work well in an illegal market. 

E.                 Reputation makes you an easier target for the police, and warrantees are hard to enforce in an illegal market.  Therefore you get a lot of rotgut liquor, adulterated narcotics, venereal disease...  This is due to prohibition, not the products themselves.

VI.               The Economics of Organized Crime

A.                 Organized crime is the market's response to prohibition.  Organized crime usually arises to take advantage of the opportunity to supply illegal varieties and qualities of products.  Even so-called "protection money" is often literally the sale of protection to persons in illegal occupations.

B.                 Organized crime families have two important cost advantages:

1.                  Reducing the probability and severity of punishment.

2.                  Ability to enforce their own contracts.

C.                Organized crime helps mitigate the decline in product quality, since it has to maintain its reputation.

D.                Sometimes (but not always), organized criminal firms use their muscle to enforce monopoly privileges for themselves.  This works just like a government-owned monopoly, except the "government" is the crime family.

1.                  Question:  Shouldn't proponents of prohibition prefer monopolized supply of prohibited goods to competitive supply?