Racing to the Bottom: Competition and Quality

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