Quality Leadership When Regulatory Standards are Forthcoming

In many markets, governments set minimum quality standards while some sellers choose to compete on the basis of quality by exceeding them. We analyze this phenomenon using a model of vertical product differentiation, interpreting quality as an "environmental friendliness" characteristic fully internalized by the consumer. A standard raising minimum quality then reduces maximum pollution per unit of products sold in the market. In the duopoly case, this leads to increased product qualities, increased quantities sold of both products, and reduced total pollution. As a result, total welfare increases. However, industry profits fall due to increased competition caused by reduced quality differentiation. If the high-quality firm can commit to a specific quality level before regulations are promulgated, it can induce the regulator to weaken its standards, with the result that welfare is reduced