Quality and location choices under price regulation

Abstract

In a model of spatial competition, we analyse the equilibrium outcomes in markets where the product price is exogenous. Using an extended version of the Hotelling model, we assume that firms choose their locations and the quality of the product they supply. We derive the optimal price set by a welfarist regulator and find that this (second-best) price causes over-investment in quality and an insufficient degree of horizontal differentiation (compared with the first-best solution) if the cost of investing in product quality, or the transportation cost of consumers, is sufficiently high. Comparing with the case of price competition, we also identify a hitherto unnoticed benefit of regulation, namely improved locational efficiency.