Wednesday, April 18, 2012

Market competition and product quality

There is common perception that more competition can lead to lower quality, as firms try to lower prices. Of course, this presupposes that buyers do not require quality, or that the trade-off between prices and quality is tilted towards giving up quality. Thus, a lowering of quality cannot be a general phenomenon, but must be limited to some good. One area where we would think that quality is important and would not be traded off is health care. Yet there is evidence that where competition increased, lower quality has been provided. How could that be?

Kurt R. Brekke, Luigi Siciliani and Odd Rune Straume provide a theory that can can explain this under particular circumstances: First, sellers need to be motivated in the sense that they care for quality. Second the marginal utility they get from profits is decreasing as they make higher profits, which implies risk-aversion. These assumption does not seem unreasonable, especially for health care provision (but not for the financial industry, for example, where the bonus payment is so important). The intuition of more competition yielding lower quality is rather twisted: increase competition, and prices fall. Profit margins are smaller, hence also profits. With a higher marginal utility of profit, sellers try harder to increase profits, and quality is a dimension that is available. How to counteract this? Make people care more about quality (how?), tax lower quality (how?). Not obvious.

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