Spatial Competition in Quality

Abstract

We develop a model of vertical innovation in which firms incur a market entry cost and position themselves in the quality space. Once established, firms compete monopolistically in the quality space, selling to consumers with heterogeneous tastes for quality. Exogenously growing productivities induce firms to sequentially enter the market at the top end of the quality spectrum. We spell out the conditions under which the entry problem is replicated over time so that each new entrant improves incumbent qualities in fixed proportions. Sequential market entry overcomes the asymmetry of the location problem that unavoidably arises in the quality space: the quality spectrum has a top and a bottom end. Handling this asymmetry, a feature absent from the circular world of the related Lancaster (1966) model, is our main technical contribution. We embedded this model in a setup of Schumpeterian endogenous growth, yielding insights into the nature of "creative destruction" and the motives for innovation in vertically differentiated markets.