Racing to the Bottom: Competition and Quality

27 Pages Posted: 8 Nov 2007

See all articles by Limor Golan

Limor Golan

Washington University in St. Louis, Department of Economics; Federal Reserve Banks - Federal Reserve Bank of St. Louis

Christine A. Parlour

University of California, Berkeley - Finance Group

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: November 7, 2007

Abstract

We model competition between risk-neutral principals who hire weakly risk-averse agents to produce a good of variable quality. The agent can increase the likelihood of producing a high-quality good by providing costly effort. We demonstrate that, when the agent is strictly risk-averse, the cost of providing incentives increases in the number of other firms in the industry. We characterize conditions under which the first-best outcome involves each firm inducing high effort. We then consider firms in competition, and identify parameter conditions under which (i) each firm induces high effort in the short run and low effort in the long run (ii) the first-best outcome has each firm inducing high effort, but long-run equilibrium results in each firm inducing low effort. Thus, in the long run, the average quality in the industry deteriorates, and increased competition leads to a "race to the bottom" in quality.

Keywords: market structure, moral hazard, quality

JEL Classification: D43, D86

Suggested Citation

Golan, Limor and Parlour, Christine A. and Rajan, Uday, Racing to the Bottom: Competition and Quality (November 7, 2007). Available at SSRN: https://ssrn.com/abstract=1028375 or http://dx.doi.org/10.2139/ssrn.1028375

Limor Golan

Washington University in St. Louis, Department of Economics ( email )

Campus Box 1120
Saint Louis, MO 63130
United States

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

P.O. Box 442
St. Louis, MO 63166-0442
United States

Christine A. Parlour (Contact Author)

University of California, Berkeley - Finance Group ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
510-643-9391 (Phone)

Uday Rajan

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

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