Quality distortions in monopolistic competition

Abstract

In this paper, we explore how heterogeneous firms decide on complementary and substitutable qualities of their products. We show that if increasing the product qualities appears to be relatively costly, more productive firms choose higher complementary quality but lower substitutable quality. We also document distortions that arise in our framework. Specifically, we find that in the market equilibrium, firms tend to underinvest in substitutable quality but overinvest in complementary quality compared to the first best allocation. Using data from pizzerias in Oslo, Norway, we provide a calibration exercise to estimate welfare losses due to the quality distortions.