Price and Quality Competition: The Effect of Differentiation and Vertical Integration

Abstract

This paper studies an instance of price and quality competition between firms as seen in the recent Internet market. Characterizing this competition from a microeconomic viewpoint, we consider two possible business strategies that firms can utilize to overcome the competition - the differentiation and the vertical integration with another complementary firm. We show an interesting result not seen in the well-known Bertrand price competition: not only does the differentiation always increase the firms' profits, but also it can increase the consumer's welfare in a quality-sensitive market. We further derive that the monopolistic vertical integration that excludes the combination-purchase with a competitor's product is beneficial for both the integrated firm and its consumers.