Vertical differentiation: entry and market coverage with multiproduct firms

We consider a multiproduct monopoly producing many qualities of the same product in a market where the consumers' income distribution is sufficiently wide so as to rule out the case of a natural monopoly. In this context, Mussa and Rosen (1978, Journal of Economic Theory 18, 301-317) show that a protected monopolist may decide to leave part of the market unserved. Here, we examine whether entry threats are sufficient to induce complete market coverage. We assume that the number of qualities in the incumbent's product line is endogenously determined and that both the incumbent and the entrant face the same fixed cost of introducing a new quality. Thus, an increase in the fixed cost does not necessarily make entry more difficult. As it turns out, there are disjoint intervals of the fixed cost for which the monopolist's optimal policy is sufficient to deter entry even if it implies that part of the market remains uncovered. When entry is not blockaded, the monopolist may find it profitable to react to entry threats by upgrading his intermediate qualities. The resulting higher prices will discourage more consumers from purchasing the product. Hence, while actual entry would have resulted in complete market coverage, potential entry may not improve, and in many cases may worsen, the extent of market coverage. (C) 1997 Elsevier Science B.V.