Quality provision with heterogeneous consumer reservation utilities

This study examines a firm's quality and price decisions when consumers differ not only in their willingness-to-pay for quality but also in their reservation utility for the basic product. We find that while the firm offers lower-quality products when consumers' valuations for quality deteriorate, the optimal quality may increase with a negative shift in consumers' reservation utilities. We also investigate the optimal price and quality of the products within a vertically differentiated product line when the number of products is exogenously given. The existing literature shows that when consumers differ only in their willingness-to-pay for quality, the firm sets the efficient quality for consumers with the highest valuation for quality, whereas the concern for cannibalization pushes down the quality of inferior products. We find that when consumers are heterogeneous in both their reservation utility and valuation for quality, the concern for cannibalization may distort the quality upwards, even for consumers with the highest willingness-to-pay for quality. In addition, a low-quality product may enjoy a higher profit margin than a high-quality product within the product line.