Equilibrium Demand Elasticities across Quality Segments

Empirical studies find substantial differences in demand elasticities and associated markups among products of different quality. This paper analyzes the theoretical determinants of such variation. We present a simple model that allows for horizontal and vertical differentiation and accounts for endogenous entry. We find that most economic forces in our model, such as consumers’ price sensitivity, the scope for product differentiation, and sunk costs of entry, are likely to induce lower equilibrium demand elasticities for higher quality products. In contrast, other economic forces, such as marginal cost of production and the distribution (across consumers) of the willingness to pay for quality, may induce the opposite pattern. These results provide an organizing framework through which empirical findings may be interpreted, and may also help to predict variation in demand elasticities for markets in which empirical estimates of elasticities are unavailable or infeasible to obtain.