Abstract

A wide spectrum of technologies, producing a vast array of product qualities, coexists in modern markets today. Many of these markets are also characterised by what is commonly known as localized competition that refers to a special industrial structure in which different firms compete directly with different groups of rivals. We explore the endogenous choice of product quality in localized competition such that the choice of product quality by a seller has effects only on those rivals who share the common market segment. In the proposed model multiple equilibria may occur and the present analysis may be seen as a rationalization for the idea that a market segment may become trapped in a “low-quality” equilibrium. In the presence of multiple equilibria and the quality trap, the industrial policy may have a welfare-enhancing role in coordinating expectations. We then extend the model to highlight the conditions that can preclude the possibility of the quality trap in localised competition.

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