Vertical Differentiation –a box of worms

The Demand Side:

Consider first the case of a pure monopoly with a single product. A higher quality
will increase demand, ceteris paribus. Since all consumers rank varying qualities in
the same order, a higher quality must increase the reservation price for each unit.
And with any increase in demand, marginal revenue also increases.
Unlike the model in the text, it is also plausible that the size of the market would
increase with a higher quality. Some consumers might be unwilling to purchase
the lower quality at any price. (This would depend on the specification of the
utility function.)

The Cost Side:

A higher quality product will typically cost more to provide. But the higher cost
could be fixed or variable, or maybe both. And with any increase in variable costs,
marginal cost must increase as well.

Profit Maximization:
The profit-maximizing monopoly must choose both the quality of the product as
well as the quantity produced of the product.
1. For a given choice of quality, MR must equal the MC of production at that
quality.
2. For a given choice of quantity, the additional MR from increasing quality of
each unit should equal the addition to MC from increasing the quality of that
quantity of output.
Multi-product Firms with vertical differentiation:
Consider a high quality seller who considers adding a second, lower quality
product. The lower quality product will serve as a substitute (if only a weak one)
for the higher quality product. The monopolist wants to limit the extent to which
it competes with itself.
The larger the quality difference and hence the optimal price difference, the
fewer customers will switch products, increasing the incentive to add the second
product.
But if the cross-price elasticity is sufficiently small across the different qualities,
then they are really in distinct markets. With a sufficient difference in quality,
products do not effectively compete. So in many cases of vertical differentiation
with multi-product firms, the market is effectively segmented by quality.
The differing qualities across products may also shift the focus of competition
away from price and more toward quality.