Price competition, willingness to pay, and demand externalities under vertical differentiation

This paper explores how price competition is shaped by vertical differentiation, when demand externalities affecting the consumption of high-quality goods (such as a bandwagon effect) interact with income heterogeneity. To do so, we study how these externalities influence prices in a vertically differentiated duopoly, where the consumers’ willingness to pay for high-quality goods depends on market size, and the distribution of income is logconcave. We prove the existence and uniqueness of a Nash equilibrium in price strategies. Our findings reveal that stronger externalities favouring high-quality goods lower low-quality prices, but do not always raise high-quality prices: the impact on price competition depends on the income distribution, as the latter affects the co-movements of high-quality demand and its price elasticity.