ENTRY AND PRODUCT QUALITY UNDER PRICE REGULATION

Spence (1975, footnote 5, p. 420) has shown that, in equilibrium, a pr ice-regulated monopoly will supply a socially suboptimal level of qual ity. This tendency to undersupply quality has been used to justify an expansion of regulatory controls to the quality dimension in certain r egulated industries (e.g., electricity and telecommunications). In thi s paper, we examine the effects of entry on equilibrium product qualit y in an industry which is price-regulated. A generalized conjectural v ariation model is used which allows both monopolistic and oligopolisti c market structures. Using this model, we find that regulation general ly leads to a socially nonoptimal (either too high or too low) level o f 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 regulat ed market will cause equilibrium quality to move in a social-welfare-i mproving direction, regardless of the direction of the original distor tion.