Entry and product quality under price regulation

Spence (1975, footnote 5, p. 420) has shown that, in equilibrium, a price-regulated monopoly will supply a socially suboptimal level of quality. This tendency to undersupply quality has been used to justify an expansion of regulatory controls to the quality dimension in certain regulated industries (e.g., electricity and telecommunications). In this paper, we examine the effects of entry on equilibrium product quality in an industry which is price-regulated. A generalized conjectural variation model is used which allows both monopolistic and oligopolistic market structures. Using this model, we find that regulation generally leads to a socially nonoptimal (either too high or too low) level of quality, where the direction of the resulting departure from optimal quality depends upon the conjectures that firms form. Spence's result is obtained as a special case. We then demonstrate that a policy that encourages (or, at least, does not discourage) entry into the regulated market will cause equilibrium quality to move in a social-welfare-improving direction, regardless of the direction of the original distortion.