Conference Paper Minimum Quality Standards and Non-Compliance

Transcription

1 econstor Der Oen-Access-Publikationsserver der ZBW eibniz-informationszentrum Wirtschaft The Oen Access Publication Server of the ZBW eibniz Information Centre for Economics Voßwinkel, Jan; Birg, aura Conference Paer Minimum Quality Standards and Non-Comliance Beiträge zur Jahrestagung des Vereins für Socialolitik 015: Ökonomische Entwicklung - Theorie und Politik - Session: Innovation, No. E1-V1 Provided in Cooeration with: Verein für Socialolitik / German Economic Association Suggested Citation: Voßwinkel, Jan; Birg, aura (015) : Minimum Quality Standards and Non-Comliance, Beiträge zur Jahrestagung des Vereins für Socialolitik 015: Ökonomische Entwicklung - Theorie und Politik - Session: Innovation, No. E1-V1 This Version is available at: htt://hdl.handle.net/10419/113 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch geseichert und koiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Oen-Content-izenzen (insbesondere CC-izenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten izenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and coied for your ersonal and scholarly uroses. You are not to coy documents for ublic or commercial uroses, to exhibit the documents ublicly, to make them ublicly available on the internet, or to distribute or otherwise use the documents in ublic. If the documents have been made available under an Oen Content icence (esecially Creative Commons icences), you may exercise further usage rights as secified in the indicated licence. zbw eibniz-informationszentrum Wirtschaft eibniz Information Centre for Economics

2 Minimum Quality Standards and Non-Comliance aura Birg Jan S. Voßwinkel Setember 015 Abstract This aer studies the e ect of non-comliance with a minimum quality standard on rices, quality, and welfare in a vertical di erentiation model. Non-comliance with a minimum quality standard by a low-quality rm reduces quality levels of both rms and shifts demand from the low-quality to the high-quality rm. Under non-comliance, an increase in the standard increases the quality of both roducts and shifts demand from the highquality roduct to the low-quality roduct. Stricter government enforcement decreases the quality level of the low-quality rm and shifts demand from the low-quality rm to the high-quality rm. Non-comliance of the low-quality rm increases ro ts for both rms, reduces consumer surlus, and increases or decreases welfare deending on the market size, the detection robability, surveillance cost, and the minimum quality level. JE Classi cation: K4, 13, 50 Keywords: minimum quality standard, non-comliance, enforcement 1 Introduction This aer studies the e ect of non-comliance with a minimum quality standard on rices, quality levels, and welfare in a vertical di erentiation model. Also, it exlores the e ect of an increase in the minimum quality standard and the e ect of a higher level of government enforcement e ort on rices, quality levels, and welfare under non-comliance. In the Euroean Union rms investments in roduct quality are not only driven by consumer references, but also by mandatory minimum quality standards that are alied in order to limit external e ects such as harmful emissions or risks to consumers. owever, non-comliance with these minimum quality standards seems to be not just an excetion, but it aears to be the rule in many cases. A signi cant number of household electrical roducts imorted from outside of the EU does not comly with the resective minimum quality standards. The Euroean Commission reorts that only 5% of the mobile household lights tested fully comly with the resective Deartment of Economics, University of Göttingen, Platz der Göttinger Sieben 3, Göttingen, Germany, laura.birgwiwi.uni-goettingen.de. Deartment of Economics, NGU Nürtingen-Geislingen University, Neckarsteige 6-10, 76 Nürtingen, Germany, jan.vosswinkelhfwu.de. 1

3 administrative or technical requirements. Only about 17% of all cord extension sets meet all requirements, while 5% of the cord extension sets tested are considered unsafe. Other examles are energy saving lams (3% technical non-comliance), consumer entertainment electronic roducts (50% technical non-comliance), imorted toys (55% technical non-comliance), and Christmas lightning (Euroean Commission, 013b, Annex 7). Consumers often might not be aware of roducts not ful lling all safety requirements and by roducts that do not meet all requirements. One reason could be that consumers trust in the cometent market surveillance authorities. Since the question of ful lling the standards is a comlex issue, many consumers may simly have to rely on market surveillance authorities, because they are unable to observe the quality of a roduct in all its dimensions and/or lack su cient knowledge of the resective standards. Alternatively fragmented surveillance rules could exlain consumers unawareness. If national market authorities treat the same roducts di erently within the single market, consumers lack a clear signal of con dence. Also, consumers might exect that a roduct not meeting all resective requirements comletely will not automatically be unsafe or cause environmental damage. Another exlanation for the fact that consumers buy roducts that do not meet the relevant standards would be a lower reference for safety or environmental issues by consumers comared to the standard-setting authority. E ective market surveillance aims at identifying unsafe or environmentally harmful roducts, which are then to be taken o the market. Market surveillance is carried out by the authorities of the member states (Euroean Commission, 013a). The internal market with roducts circulating freely within the Euroean Union oses a articular challenge to market surveillance. Cross-border coordination of member states activities is vital for e ective consumer rotection in the internal market. Unsafe roducts not ful lling roduct safety requirements may enter the EU market via third countries, if national activities are not coordinated su ciently. Market surveillance is incomlete today. The market surveillance rules are fragmented and di erent legal bases aly (Regulation 765/00 and the General Product Safety Directive 001/95/EC, or sector-seci c Euroean Union harmonization legislation). This may create confusion among national market authorities, consumers, and rms. Product safety requirements determining whether a roduct is safe and may be marketed are not always clear and consistent. (Euroean Commission, 013a). In 013, the Euroean Commission has roosed the so called Product Safety and Market Surveillance Package with the aim to imrove consumer roduct safety and to strengthen market surveillance of roducts circulating on the internal market by better coordinating member states activities and streamlining the various legal bases (Euroean Commission 013a). The main idea of the Product Safety and Market Surveillance Package is to increase the robability that roducts that do not ful ll all requirements are detected. So safety is the main focus of the roosed ackage. The roosed amendments by the Euroean Parliament focus also on the surveillance of environmental an energy e ciency standards (Euroean Parliament, 014). An alternative measure for strengthening the market surveillance is the increase of alicable

4 minimum quality standards. This leads to a higher quality level of comliant roducts and might otentially increase the quality level of non-comliant roducts. So governments are able to chose between both instruments. Since both instruments might be accomanied by di erent sidee ects, the governments have to chose carefully which instruments ts best in which situation. Increasing the safety of consumers or third arties might require a di erent instrument than reducing external e ects caused by a grou of roducts. This aer relates to the literature of minimum quality standards in several ways. ike the majority of aers on minimum quality standards (e.g. Ronnen, 1991 and Crames & ollander, 1995), we consider duoolistic markets, where single roduct rms face minimum quality standards as exogenous constraints. We assume that quality imrovements result in higher variable costs as in Crames & ollander (1995), Ecchia & amberti (1997), and Petrooulou (013). This assumtion may be aroriate for many household aliances, toys etc., where quality imrovements stem (artly) from using high-quality materials or more comlex roduction rocesses. The literature on minimum quality standards has stressed that quality choices of oligoolistic rms di er from socially otimal levels (Scara, 199). The literature tyically nds that quality levels of roducts increase with the level of the minimum quality standard (Ronnen 1991, Motta & Thisse, 1993) as long as the quality standard does not reduce the number of rms in the market (Motta & Thisse, 1993). Recently, several aers have analyzed the e ects of non-comliance with a minimum quality standard. Faure, Schleich & Schlomann (013) test non-comliance with the EU Energy abeling Directive in a samle of 100,000 aliances from 1,400 retail stores in 7 EU member states. They show that erceived costs and bene ts, normative motives, and social in uence may exlain retailer comliance with the EU energy labeling rogram. Other aers analyze mainly the e ect of non-comliance with environmental standards. For instance, atcher (007) comares emission level standards and standards exressed in terms of emissions er unit of outut (ratio standards) under non-comliance. e shows that emission level standards and ratio standards lead to di erent results with resect to emissions and outut. Arguedas, Camacho & Zofío (010) analyze rm s incentives to adot abatement technologies, if non-comliance occurs. They nd that under certain assumtions imerfect comliance increases rms incentives to invest in abatement technologies, if emission standards are alied. Arguedas, Cabo & Martín-errán (014) analyze the dynamic interaction of more stringent ollution limits and nes overtime in a dynamic setting. Fine discounts in exchange for rm s environmentally-friendly investment in caital hel rms to comly with more stringent standards and are socially desirable. Arguedas (013) studies otimal nes for exceeding ollution standards. She shows that under non-comliance an otimal ne should decrease with investment e ort and ositive social costs of sanctioning, whereas under full-comliance the ne should be indeendent of investment e orts. Chen & Serfes (01) analyze the e ect of a minimum quality standard in a vertical di erentiation model, when the government receives only a noisy signal of quality and imoses 3

5 a ne on rms that do not comly with the minimum quality standard. They show that in their setting a minimum quality standard may reduce social welfare. Our aer focuses on the comarison of two other olicy instruments: an increase of the minimum quality standard and an increase of the surveillance activities under non-comliance. 1 In addition, we show that strategic behavior of the low-quality rm resulting in non-comliance can increase social welfare, even if the minimum quality standard does not decrease social welfare er se. In this aer, we study the e ect of non-comliance with a minimum quality standard on rices, quality levels, and welfare in a vertical di erentiation model following Ecchia & ambertini (1997). We endogenize quality and assume variable cost of quality imrovements. Consumers are heterogeneous with resect to their reference for quality. The introduction of an exogenous minimum standard may be motivated by external e ects such as environmental harmful ollution or risks to consumers and third arties. We assume a level of the minimum quality standard that is tough, i.e. a minimum quality level that is binding for the high-quality rm. Exceeding the highest quality level available on the market does not imly that this quality level is technically infeasible. It only imlies that this level is not ro t-maximizing for any rm without regulation. 3 Non-comliance with a minimum quality standard may increase the low-quality rm s ro t. This behavior reduces both quality levels, it increases the rice for the high-quality roduct, decreases the rice for the low-quality roduct, and shifts demand from the low-quality to the high-quality rm. Under non-comliance, an increase in the standard increases the quality di erence, increases the rice di erence, and shifts demand from the high-quality rm to the low-quality rm. A higher level of government enforcement decreases the quality level of the low-quality rm, but shifts demand from the low-quality rm to the high-quality rm. Noncomliance reduces consumer surlus, but increases roducer surlus, and increases or decreases welfare, deending on the market size, the e ect of quality levels of the externality, the detection robability, surveillance costs, or the minimum quality level. Although overall consumer surlus declines, a subgrou of consumers might gain from non-comliance. The rest of the aer is organized as follows. In the next section, the vertical di erentiation model is resented and the case of no government intervention, the case of full comliance with the minimum quality standard, and the case of non-comliance by the low-quality rm with the standard are analyzed. Section 3 analyzes the e ect of enhancing the minimum quality standard 1 Chen & Serfes (01) also analyze the e ect of an increase in the ne. Referring to the maximum quality level on the market in standard-setting corresonds to the common aroach by the Euroean Commissions of referring to best available techniques. The Directive on industrial emissions de nes available techniques as those develoed on a scale which allows imlementation in the relevant industrial sector, under economically and technically viable conditions, taking into consideration the costs and advantages, whether or not the techniques are used or roduced inside the Member State in question, as long as they are reasonably accessible to the oerator. It is not necessary that this technique is used in the market under consideration. 3 A mild minimum quality standard would lead to qualitative similar results. There are also methodological reasons for our assumtion: If the level of the minimum quality standard would be lower than the quality level of the high-quality rm without regulation, non-comliance of the low quality rm would be equivalent to the case of no regulation. 4

6 as well as stricter enforcement of a given standard and discusses the choice of olicy instruments. Section 4 studies welfare. Section 5 concludes. The Model Following Ecchia & ambertini (1997), consider a duoolistic market with vertical roduct differentiation. Assume that a roduct is sulied in two quality levels, s and s, with s > s, and that each rm sulies only one quality level. The roduction technology is characterized by variable cost, which are convex in quality and linear in quantity: C i s i q i. (1) Firms use higher quality materials or more comlex roduction rocesses to enhance the quality level of their roducts. This may be an aroriate assumtion for many household aliances like vacuum cleaners, for consumer entertainment roducts or for toys. For these roducts, non-comliance is a frequent henomenon (Euroean Commission, 013b, Annex 7). Consumers are heterogeneous with resect to their reference for quality, as in Mussa & Rosen (197). They are characterized by a reference arameter, which is uniformly distributed on the interval [a; b] with b a Consumer value all roduct characteristics including safety and environmental asects. Each consumer buys at most one unit of the most referred good. The utility derived from no urchase is zero, while a consumer who buys one unit of the good obtains a net utility of U s i i ; i ;. () The consumer heterogeneity can be interreted as di erences in income or as di erence in consumtion atterns. Frequent usage may be accomanied by a higher willingness to ay for quality. Note that can also be interreted as the marginal rate of substitution between income and quality (Tirole, 19). The marginal consumer indi erent between urchasing the high-quality good and the lowquality good is given by s s. ence, demand for the high-quality good and the lowquality good resectively is given as Firms ro ts are given as q b ; q a. (3) s s s s i i s i qi : (4) Cometition follows a three-stage game: In the rst stage, the government chooses a minimum quality level at an exogenous intensity and the intensity of market surveillance. In the second 4 Assume b > b min 5 4 [a; b]. to guarantee equilibrium existence (Ecchia & ambertini, 1997). In equilibrium 5

7 stage, rms choose quality levels. In the third stage, rms comete in rices..1 No Regulation Consider rst a system with no government intervention. Prices and quality levels can be found in the Aendix. Firms are free to choose quality levels. Both quality levels increase in the maximum willingness to ay b. The di erence between quality levels s s s is indeendent of b. Both equilibrium rices and the rice di erential increase in b. The duooly is symmetric, quantities are q q 1.. Minimum Quality Standard and Comliance Now assume the introduction of a minimum quality standard, with which both rms comly. We assume a level of the minimum quality standard that is tough, i.e. a minimum quality level that is set equal to the highest quality level available in the market or even exceeds this quality level (S > s ). Exceeding the highest quality level available on the market does not imly that this quality level is technically infeasible. It only imlies that this level is not ro t-maximizing for any rm without regulation. A mild minimum quality standard would lead to qualitative similar results. Also assume S S max b+1 to guarantee that no rm exits the market. Prices, quality levels, and quantities can be found in the Aendix. The low-quality rm sets the quality level to the required minimum quality level. The highquality rm s otimal resonse is to raise its quality level to sustain roduct di erentiation. 5 The introduction of the minimum quality standard increases both quality levels (s C > s, s C > s ). Both quality levels increase in the minimum quality standard, with the increase in the quality level of the low-quality rm exceeding that of the high-quality rm (0 < sc increase in the standard decreases the quality di erence. < sc ). Thus, an The introduction of the minimum quality standard increases both rices ( C >, C > ). Firms incur higher variable costs. The quality level of both roducts increases. The willingness to ay for the increased quality increases also. 6 Both rices increase in the minimum quality standard. An increase in the standard decreases the rice di erential ( C > C ). The introduction of the minimum quality standard shifts demand from the high-quality rm to the low-quality rm, due to the increase in quality levels (q C < q, q C > q ). An increase in the standard enhances this demand-shifting e ect ( qc < 0, qc ). Proosition 1 summarizes the e ect of a minimum quality standard for both rms meeting the standard. Proosition 1 Suose a tough minimum quality standard is introduced and both rms comly with the standard. Then the standard i) increases both quality levels, ii) increases both rices, 5 omogeneous roducts would result in Bertrand rice cometition with marginal cost ricing and zero ro ts. 6 Note that quality levels are not ro t maximizing anymore. 6

8 and iii) shifts demand from the high-quality to the low-quality rm. An increase in the standard i) decreases the quality di erence, ii) decreases the rice di erence, and iii) enhances the demand-shifting e ect..3 Minimum Quality Standard and Non-Comliance Now assume that the government cannot monitor comliance with the standard erfectly. Violations against the standard are detected with robability. Government incurs surveillance costs F () 7 (Rousseau & Proost, 005). If discovered by the government, roducts not comlying with the standard are con scated. The introduction of a ne for non-comliance has no e ect on rices and quality levels, because this it would only constitute an ufront ayment. 9 Prices, quality levels, and quantities can be found in the Aendix. The low-quality rm does not comly with the standard. This is ro table ( > C ) for many combinations of market size b, detection robability ; and level of the minimum quality standard S (see Figures 6-9 in the Aendix). So in this aer non-comliance is not a mere assumtion, but an endogenous result of ro t-maximizing behavior. Consumers may distinguish roducts of a higher quality level from roducts of a lower quality level, but cannot observe whether the standard is ful lled. Alternatively, they do not base their urchase decisions on standard ful llment, because they either have a lower reference for safety or environmental issues than the government or because they do not exect that a roduct not meeting all resective requirements comletely will be unsafe or cause environmental damages. Both rms know the quality level of both roducts. Firms ro ts are given as (1 ) s q ; s q. (5) In resonse to the low-quality rm not comlying with the standard, the high-quality rm lowers its quality level to the required minimum quality level. The choice of a higher quality level is not otimal for the high-quality rm. So in this setting the minimum quality standard imosed by the government de nes in fact a maximum quality level available on the market. Quality levels are strategic comlements. So non-comliance with the standard of the low-quality rm reduces both quality levels (s available in the market. < sc, s < s C ), the average quality level and the maximum quality An increase in the minimum quality requirement under non-comliance increases both quality levels, with the quality level of the low-quality rm increasing by less than the quality level of 7 Assume F and F. In the EU, this is one of the common otions for action by the member states customs authorities, if a roduct resents a serious risk. 9 A su ciently high ne would result in no non-comliance at all. We assume that this is non-feasible. 7

9 the high-quality rm (0 < s < s ). This is, in contrast to the case of full comliance, the quality di erence increases in the standard ( s ). Non-comliance of the low-quality rm increases the rice for the high-quality roduct, if S or are su ciently high and decreases the rice for the low quality roduct ( > C if S > S e _ S < S e ^ > ; < C ). Both rices and the rice di erence increase in the standard ( > ). Non-comliance of the low quality rm induces a lower rice for low-quality roducts because consumers are willing to ay less for lower quality and lower cost. The rice for the high quality roduct deends ositively on the quality di erence s, since a higher relative quality level leads to a cometitive advantage of the high-quality rm, whereas deends negatively on s. The increase of the rice di erence induced by non-comliance is lower than the induced increase of the quality di erence. Non-comliance of the low-quality rm increases the quantity of the high-quality roduct and decreases the quantity of the low-quality good (q > qc, q < q C ). Thus, non-comliance has the oosite e ect as comared to the introduction of a minimum quality standard: It shifts demand from the low-quality rm to the high-quality rm. An increase in the standard, however, again shifts demand from the high-quality rm to the low-quality rm ( q q < 0, ). Proosition summarizes the e ect of non-comliance with the minimum quality standard by the low-quality rm. Proosition Suose the low-quality rm does not comly with the minimum standard. Then non-comliance i) reduces both quality levels, ii) causes the high-quality rm to set its quality level according to the minimum quality level, iii) increases the rice for the high-quality roduct, if the minimum quality standard or the detection robability are su ciently high, and decreases the rice for the low-quality roduct, and iv) shifts demand from the low-quality rm to the highquality rm. An increase in the standard i) increases the quality di erence, ii) increases the rice di erence, and iii) shifts demand from the high-quality to the low-quality rm. 3 Government Policies This section comares the consequences of two government olicies: Raising the minimum quality standard and stricter enforcement of an existing minimum quality standard. Prices, quality levels, and quantities can be found in the Aendix. 3.1 Raising the Minimum Quality Standard Quality levels of both tyes of the roduct, s and s, are strategic comlements. An increase in the minimum quality standard S leads to an increase of both quality levels s and s under comliance and under non-comliance. It causes both rices to rise in the case of comliance as

10 well as in the case of non-comliance. An increase in the standard decreases the quantity of the high-quality roduct. Under non-comliance, an increase in S has a direct e ect on s, because the - rm meets exactly the minimum quality standard s. Via best resonse of the - rm this s. An increase in S causes an increase in the di erence causes an increase of s in quality levels, because the high-quality rm increases quality more than the low-quality rm s. The low quality rm faces the risk that a share of its roduction is con scated. This leads to a lower incentive to invest in quality. Both rices increase in S ;. The rice di erence between high-quality roducts and low-quality roducts increases, since the low quality rm invests in quality by less. In addition, the ability to increase rices following an increase in costs due to higher quality (but not ful lling the minimum quality standard) is damened by the risk of non-comlying roducts being detected and con scated by the market authorities. An increase q in S shifts demand from the high-quality rm to the low-quality rm < 0; q. Proosition 3 summarizes the main results Proosition 3 Under non-comliance, an increase in the minimum quality level i) leads to an increase of both quality levels and both rices, ii) decreases the quantity of the high-quality roduct, iii) increases the quantity of the low-quality roduct, and iv) increases the di erence in quality levels and v) increases the rice di erence between the high-quality roduct and the low-quality roduct. 3. Stricter Enforcement The regulatory authority may also send more resources to increase the detection robability in order to reduce the share of non-comliant roducts and increase the average quality level of roducts that are available on the market. This is one of the main ideas of the Product Safety and Market Surveillance Package roosed by the Euroean Commission (Euroean Commission, 013a). s An increase in government enforcement decreases the quality level of the low-quality rm: < 0. The reason is that an increase of the detection robability makes it less ro table for the low quality rm to invest in quality, as a larger share of roducts is con scated. The s s quality level of the high-quality rm remains unchanged due to stricter enforcement. 0 The di erence between both quality level increases due to stricter enforcement. A higher level of government enforcement leads to a rice increase of the high-quality roduct and a rice decrease of the low-quality roduct, < 0 if the maximum willingness to ay for quality b is su ciently high 10. It shifts demand from the low-quality rm to the high quality rm 10 < 0 if b 1:7. q q,. < 0 9

11 Proosition 4 summarizes the e ect of increased government enforcement. Proosition 4 Suose the low-quality rm does not comly with the minimum standard. An increase in government enforcement i) decreases the quality level of the low-quality roduct, ii) increases the rice for the high-quality roduct and decreases the rice for the low-quality roduct, if the maximum willingness to ay for quality is su ciently high, and iii) shifts demand from the low-quality rm to the high-quality rm. 3.3 Choice of Policy Instrument An increase of S and an increase of may be seen as olicy substitutes under non-comliance, both with the aim to increase the quality of roducts on the market. But both instruments have di erent consequences for the regulatory authority, the quality of non-comliant roducts, rices, and consumtion of comliant and non-comliant roducts. An increase in the minimum quality standard is free of cost from the government s oint of view. It increases the average quality and increases the lowest quality level. An increase in S increases rices. In addition, it increases consumtion of low-quality roducts. An increase in the detection robability, in contrast, causes an increase in government sending for market surveillance. It decreases the average quality level and the lowest quality level available on the market, while the quality of the high quality roduct remains unchanged. It increases rices for the high-quality goods and decreases rices for the low-quality good. It increases consumtion of high quality roducts. If the intention of the government is to guarantee a minimum quality level of all roducts sold on the market, an increase in S seems to be favorable to an increase in, because it increases both the average and the lowest quality level. The last e ect is imortant, if a low quality level is associated with a risk for consumers, because it makes low-quality roducts more safe. If, however, the intention of the government is rotection of high-quality rms, an increase of is the better instrument. If consumers buying the low-quality roducts are at risk or ollute the environment, while there is no such risk or ollution e ect associated with high-quality roducts, increasing might be referable, because it increases consumtion of high quality roducts, although it makes low-quality roducts even worse and more money is sent. Of course, this does not hold when it is the increased detection robability that induces a decrease of s below a critical level and thereby causes a new risk. Product characteristics may determine which instrument is referable. A roblem arises if roducts both are otentially hazardous and roduce externalities (energy saving lams may be an examle). The total e ect with resect to quality levels and consumtion is ambiguous, if both instruments are alied. In addition, higher level of government enforcement may misguide consumers to have more con dence in all roducts available on the market. Therefore a higher level of government enforcement should be accomanied by an additional rogram that raises the awareness for safety roblems of consumer roducts. 10

12 4 Welfare Analysis Assume the regulator s ayo is R q s q s, where denotes the externality and denotes the e ect of the roduct quality on reducing the externality from the regulator s ersective Welfare is given as the sum of ro ts, consumer surlus, and the regulator s ayo minus surveillance cost (W + + CS + R regulator s ayo, and welfare can be found in the Aendix. F ). Pro ts, consumer surlus, the If both rms comly with the minimum quality standard, the minimum quality standard lowers ro ts for both rms ( C <, C < ), increases consumer surlus (CS C > CS), if S min < S < S max13, and decreases consumer surlus, if S > S (CS C < CS). The introduction of the minimum quality standard increases the regulator s ayo (R C > R). The minimum quality standard increases (decreases) welfare (W C 7 W ), if the e ect of increased quality levels on the externality is su ciently high ( > ) (low ( < )). An increase in the minimum quality standard decreases ro ts of both rms ( C ( CSC < 0), but increases the regulator s ayo ( RC numerical simulations in the Aendix). < 0, C C W ). It increases welfare ( < 0), decreases consumer surlus ) (see Comared to the case of full comliance, non-comliance of the low-quality rm increases the - rm s ro ts ( > C ). Deending on the detection robability, non-comliance may also increase ro ts for the low-quality rm otherwise, it would comly (see gures 6-9 in the Aendix). Non-comliance reduces consumer surlus (CS < CS C ). Non-comliance also decreases the regulator s ayo, if the market size b is su ciently small. But for a su ciently large market size and a su ciently large detection robability, the regulator s ayo under non-comliance may exceed the ayo under comliance. If the market size b is su ciently small and if S is su ciently high, welfare under noncomliance may be higher than welfare under comliance (W 7 W C ). If the e ect of the roduct quality on the externality () is su ciently high and S and are su ciently low, welfare is lower under non-comliance than under comliance. Welfare increases in market size b, because the regulator s ayo increases in market size. There is a dynamic e ect of an increase in the standard: A higher standard increases the incentive for the low-quality rm for non-comlying behavior for a given detection robability. So it may be the increase in the minimum quality standard that may cause the switch of the low-quality rm from comliance to non-comliance. This switch also changes the behavior of the high-quality rm, which may also lower its roduct quality to the level of the minimum quality standard. Consumers bene t from comliance with a minimum quality standard. The grou of consumers as a whole loses due to non-comliance. But subgrous of consumers are a ected di erently by non-comlying behavior. Three subgrous can be identi ed: The rst grou consists 11 Similar results would hold, if was the weight of the regulator s ayo in the social welfare function. 1 See Pottier, Esagne & Dumas (015) for the quadratic form of the ayo function. 13 S

13 of consumers, who buy high-quality roducts under comliance and buy high-quality roducts under non-comliance. They receive a lower quality roduct, but ay a higher rice. In the second grou, consumers buy low-quality roducts under comliance and buy high-quality roducts under non-comliance. They obtain the same quality level (s C S s ) but ay a higher rice. The third grou buys low-quality roducts under comliance and still buys low-quality roducts under non-comliance. They obtain a lower quality (s C < s ), but also ay a lower rice. This is the only grou of consumers that might gain under non-comliance, rovided that the low quality does not imly damaging e ects for consumers. Proosition 5 summarizes the main results. Proosition 5 If both rms comly with the minimum quality standard, its introduction i) lowers ro ts for both rms, ii) increases consumer surlus, if S < S, and decreases consumer surlus, if S > S, iii) increases the regulator s ayo, and iv) increases (decreases) total welfare, if is su ciently high (low). Non-comliance of the low quality rm i) increases ro ts of the high quality rm and the low quality rm, iii) reduces consumer surlus and iv) reduces (increases) the regulator s ayo, if the market size is su ciently small (if the market size and the detection robability are su ciently high), and increases (decreases) welfare, if the market size b is su ciently small (large) and is su ciently low (high) and and S are su ciently high (low). The e ect of an increase in the standard on ro ts, consumer surlus, the regulator s ayo, and welfare can be found in the Aendix. ( RN C An increase in the standard under non-comliance decreases ro ts of both rms ( < 0) and decreases consumer surlus ( CS ). An increase in the standard increases (decreases) welfare ( < 0, < 0). It increases the regulator s ayo W ), if the market size is su ciently large (small), and if surveillance cost F, the minimum quality standard, and the detection robability are su ciently low (high). Under non-comliance, ro ts of the high-quality rm increase in the detection robability ( ), ro ts of the low-quality rm decrease ( < 0). Consumer surlus decreases in the detection robability ( CS < 0), the regulator s ayo increases ( R ). Under non-comliance, welfare increases in the detection robability, if the market size is su ciently large. Proosition 6 summarizes the main results. Proosition 6 An increase in the standard under non-comliance i) decreases ro ts of both rms, ii) decreases consumer surlus, iii) increases the regulator s ayo, and iv) increases (decreases) welfare, if the market size is su ciently large (small), and if surveillance cost, the minimum quality standard, and the detection robability are su ciently low (high). An increase in the detection robability i) increases ro ts of the high-quality rm, ii) decreases ro ts of the low-quality rm, iii) decreases consumer surlus, and iv) increases the regulator s ayo. It increases (decreases) welfare, if the market size is su ciently large (small). 1

14 5 Conclusion In this aer, we have studied the e ect of non-comliance with a minimum quality standard on rices and quality levels in a vertical di erentiation model. Since in many markets noncomliance with quality standards frequently occurs, our results o er some insight in the e ectiveness of standard-setting and/or increasing the detection robability. Non-comlying behavior is an endogenous result of our model. Non-comliance by the low quality rm also increases ro ts of the high quality rm, a ects the quality level of the high-quality roduct negatively, reduces consumer surlus, and increases or decreases welfare, deending on the market size, the e ect of quality levels of the externality, the detection robability, and the minimum quality level. Consumers are not a ected equally by non-comliance. While on average consumers lose due to non-comliance, a subgrou of consumers might bene t. ence, non-comliance should be considered seriously by olicy makers. Under non-comliance, an enhancement of the minimum quality standard induces an increase of the quality level of low-quality roducts, increases the average quality level but also increases the quality di erence. A higher level of government enforcement, however, lowers the quality of the low quality rm, but shifts demand from the low-quality rm to the high-quality rm. The main idea of the Product Safety and Market Surveillance Package roosed by the Euroean Commission is to increase the robability of detecting non-comliant roducts. Our results, however, show that a higher level of government enforcement has a negative e ect on the quality level of low-quality roducts. It also increases the robability, that non-comlying behavior is welfare-increasing. Therefore maybe it should be accomanied by an additional rogram that raises the awareness of consumer to roblems of non-comliant roducts. If the government is interested in the overall safety of roducts, an increase of the minimum quality standard might be referable to an increase of the detection robability. So the Euroean Commission should maybe not focus only on the detection robability, but mention also an increase of the minimum quality standard in the light of non-comliance. If consumers buying the low-quality roducts are at risk or ollute the environment (and would be also at risk or ollute the environment under an enhanced minimum quality standard under non-comliance), while there is no such risk or ollution e ect associated with high-quality roducts, increasing the detection robability might be referable, because it shifts demand from the low-quality rm to the high quality rm. For those roducts, the amendment by the Euroean Parliament, focusing also on the environmental characteristics of roducts, might be the referable strategy. 13

15 References [1] Arguedas, C. (013): Pollution standards, technology investment and nes for noncomliance, Journal of Regulatory Economics 44, [] Arguedas, C., Cabo, F., Martín-errán, G. (014): Otimal Pollution Standards and Non- Comliance in a Dynamic Framework, Working Paers in Economic Theory 014/0, Universidad Autónoma de Madrid (Sain), Deartment of Economic Analysis (Economic Theory and Economic istory). [3] Arguedas, C, Camacho, E. & Zofío, J. (010): Environmental Policy Instruments: Technology Adotion Incentives with Imerfect Comliance, Environmental & Resource Economics 47, [4] Baltzer, K. (011): Minimum Quality Standards and International Trade, Review of International Economics 19, [5] Banerjee, D. S. (003): Software Counterfeit. A Strategic Analysis and Policy Instruments, International Journal of Industrial Organization 1, [6] Banerjee, D.S. & Chatterjee, I (010): The Imact of Piracy on Innovation in the Presence of Technological and Market Uncertainty, Information Economics and Policy, [7] Boom, A. (1995): Asymmetric International Minimum Quality Standards and Vertical Differentiation, The Journal of Industrial Economics 43, [] Chen, M., & Serfes, K. (01): Minimum quality standard regulation under imerfect quality observability, Journal of Regulatory Economics 41, [9] Crames, C & ollander, A. (1995): Duooly and Quality Standards, Euroean Economic Review 39, 71-. [10] Ecchia, G. & ambertini,. (1997): Minimum Quality Standards and Collusion, The Journal of Industrial Economics 65, [11] Euroean Commission (013a): Communication More Product Safety and Better Market Surveillance in the Single Market for Products, COM(013) 74. [1] Euroean Commission (013b): Commission Sta Working Document, Imact Assessment accomanying the document Product Safety and Market Surveillance Package, SWD(013) 33. [13] Euroean Parliament (014): Euroean Parliament legislative resolution of 15 Aril 014 on the roosal for a regulation of the Euroean Parliament and of the Council on market surveillance of roducts and amending Council Directives 9/66/EEC and 93/15/EEC, and Directives 94/9/EC, 94/5/EC, 95/16/EC, 97/3/EC, 1999/5/EC, 000/9/EC, 14

16 000/14/EC, 001/95/EC, 004/10/EC, 006/4/EC, 006/95/EC, 007/3/EC, 00/57/EC, 009/4/EC, 009/105/EC, 009/14/EC, 011/65/EU, Regulation (EU) No 305/011, Regulation (EC) No 764/00 and Regulation (EC) No 765/00 of the Euroean Parliament and of the Council (COM(013)0075 C7-0043/ /004(COD)) (Ordinary legislative rocedure: rst reading). [14] Faure, C., Schleich, J. & Schlomann, B. (013): Retailer comliance with energy label regulations, Working Paers "Sustainability and Innovation" S10/013, Fraunhofer Institute for Systems and Innovation Research (ISI). [15] atcher, A (007): Firm behaviour under ollution ratio standards with non-comliance, Environmental & Resource Economics 3, 9-9. [16] Motta, M. & Thisse, J.F. (1993): Minimum quality standards as an environmental olicy. Domestic and international e ects, Nota di lavoro 0.93, Fondazione ENI Enrico Mattei, Milan. [17] Mussa, M. & Rosen, S. (197): Monooly and Product Quality, Journal of Economic Theory 1, [1] Petrooulou, D. (013): Vertical Product Di erentiation, Minimum Quality Standards, and International Trade, Oxford Economic Paers 65, [19] Pottier, A., Esagne, E., Fabert, B. P., & Dumas, P. (015): The comarative imact of integrated assessment models structures on otimal mitigation olicies, Environmental Modeling & Assessment0, 1-1. [0] Ronnen, U. (1991): Minimum Quality Standards, Fixed Costs, and the Cometition, RAND Journal of Economics, [1] Rousseau, S., & Proost, S. (005): Comaring Environmental Policy Instruments in the Presence of Imerfect Comliance A Case Study, Environmental and Resource Economics 3, [] Scara, C. (199): Minimum quality standards with more than two rms, International Journal of Industrial Organization 16, [3] Valetti, T.M. (000): Minimum quality standards under Cournot cometition, Journal of Regulatory Economics 1,

17 Aendix No Regulation s 4b+1 ; s 4b 5 5+b+16b 64 ; s s s 3 4 6b+3 q q b+16b 64. Minimum Quality Standard and Comliance Introduction of a Minimum Standard s 4b+1 S S max b+1 s C 1+b+S 3 ; s C S: C 5(b+1) S(b+1)+11S 7 C (b+1)(7 b)+s(4b 5)+19S 7 q C (b+1) 4S 9, q C 7 b+4s 9 : s C s C s C b+1 S 3 (S 4b+5)(S+b 71) C C 17 (S 4b+5)(15S+140b 175) C C C q C S 4b+5 q 1 < 0 q C S 4b+5 q 1 17 (b+1 S)(4S+7b ) 7 Increase in Minimum Standard s C 1 3 C (11S b 1) C ( C C ) 7 (19S+4b 5) 7 q C 4 9 < 0 q C 4 9 (S+5b 4) 7 < 0 Minimum Quality Standard and Non-Comliance Comliance vs. Non-Comliance s with S; s 4S (1 )( b) 6 ; q (1 ) (b ) 4S (1 ) (b ) + 4S (3 + 1) (1 )(b+5) 4S+S(1 )(4b+1)+S (3 15) (1 ) (b+5)(b ) 54(1 ) ; 16

18 5(1 ) (b ) 5(1 )(b ) S S(1 )(b )+S (19 3) 54(1 ) q q (1 )(4b+1) S+ 9(1 ), S 4(1 )(b ) 9(1 ) 4S(3+1) (1 )(b ) S min 4b+1 S max b+1 s s C ;if S > S min q min (7 47) + 4b (b + ) + 16 (b ) q max 9 (1 ) + 3b (b + 4) + (b ) (6S+ 3b+(b )) 6 C (1 ), with 1 (1 ) ( (b + 5) (b ) 3b (4b + 7)) ; S (3 (1 ) (b + 1) + 4S (3 )) ; 3 ((1 ) (b + 5) 4S) : > C ; if S > S e _ > 1 (1 ) ( (b + 5) (b ) 3b (4b + 7)) < 0; S (3 (1 ) (b + 1) + 4S (3 )) ; 3 ((1 ) (b + 5) 4S) ; if S < S 3, if S < S (1 )(b+5) 4 ; (1 )(b+5) 4 ; case I. S S min 4b+1, min( ) and min( 3 ) for S min, as (3 9)+1b(11+4b 9) (b+5)(b ) 4(10+4b 9) min ; if > 3( 640b+736b +34b 3 665) b+49b +76b (b+5)( 70b+4b +3b 3 65) ; for b > 5 6 : case II. S S max b+1, max( ) and max( 3 ) for S min, as (3 5) + 3b (b + 3) (b + 5) (b ) (5 + b 3) max if S > S (1 3 and 6 (1 ) (b + 1) + 16S (3 ) 3 (4b+1)(b )(1 )+ (4b+1)(b ) 4S(1 )(b+15+6b 7)+3S (3+1) )(b+5) 4, 3 3 and < 0; < 0 for S > Smin : C (1 ) ; if S > e S For b 3, 0:5; e S 1: 635. for S max : + 3 max (15 7+b(9 5)) 6(3 ) 1b(b+3) (14b+10b +13) > C ; if S > e S _ > C (1 ) ;with 1 (S + 5 (1 ) (b )) ; S (16S 3 (1 ) (3b 4)) ; 3 (1 ) 3 10b + 3b 5 (b ) : < C max 17

19 1 (S + 5 (1 ) (b )) ; 1 ; S (16S 3 (1 ) (3b 4)) ;if S > S 3(3b 4)(1 ) ^ S > S 3 S S max 3(3b 4) (17b 4) 3(3b 4) 16 if < (17b 4) 3 (1 ) 3 10b + 3b 5 (b ) ; 3(1 )(3b 4) 16 ; if b > b 5(3 ) case I. S S min 4b+1, min( 1 ) and min( ) for S min, as (9b 4) 3(59b+4b 3) 0 (b ) +(9(b 1) 5(b ))4 min 4 ; if < 1 case II. S S max b+1, max( 1) and max( ) for S min, as 1 and and (3b ) 3 1b + b 10 5 (b ) + (3 (3b ) 5 (b )) max ; if < 1 < C q q C (1 ) ; with 1 (1 ) (b 1) ; 4S ( + 1) ; 3 : q > qc 1 (1 ) (b 1) ; 4S ( + 1) ; 3 ; 3 S S min 4b+1, min( ) and min( 3 ) for S min, as 3 and min + b 3 ; if < 1 S S max b+1, max( ) and max( 3 ) for S min, as 3 and max 4b 3 ;if < 1 q q C (1 ) ; with 1 (1 ) (b 1) ; 4S ( + 1) ; 3 : q < q C Increase in Minimum Standard under Non-Comliance s ; with 1 (1 ) (b ) ; S (3 + 1) ; 3 : s 1 (1 ) (b ) ;if b > ; S (3 + 1) ; 3 ; 3 1

20 case I. S S min 4b+1, min( ) and min( 3 ) for S min, as min b 4 if < 1: case II. S S max b+1, max( ) and max( 3 ) for S min, as max 4b 3 if < 1 s (S s ) ; with 1 ; (1 ) (b ) ; 3 S (3 + 1) : (S s ) 1 ; 1, (1 ) (b ) ; 3 S (3 + 1) ; 3 S S min 4b+1, min( 1 ) and min( 3 ) for S min, as (S s ) 9+(16b 5)+min (1 ) ; with 1 (S (3 15) + (1 ) (4b + 1)) ; (1 ) (4b + 1) (b ) ; 3 S (S (3 + 1) (1 ) (b (b + 5))) 1 (S (3 15) + (1 ) (4b + 1)) ; 1 (1 ) (4b + 1) (b ) ;if b > ; 3 S (S (3 + 1) (1 ) (b (b + 5))) ; if S > S (1 )(b 7+3(b+5)) (3+1) ; S S max 4b 11 (7b 5) 3 (b+5) (3+1) ; (73b+70)(b ) 7b+5 if < 3(b+5) ; 3 case I. S S min 4b+1, min( 1 ) and min( 3 ) for S min, as (4b+1)(4min (7 19) 1(b 1) 4 (10b+7)) 16 ; if < 1 case II. S S max b+1, max( 1) and max( 3 ) for S max, as 1 3 and 3 and 3 and 3 and 3 and 1 3 (7b + 4 (19b + 16)) max 3 (3 ) 6b (b + 3) 14b + 10b + 13 ; if < 1 19

21 1 +3 7(1 ) ; with 1 (1 ) (b ) ; S (16S (3 + 1) (7 15) (1 ) (b )) ; 3 (S (19 3) (1 ) (b )) : 1 (1 ) (b ) ; S (16S (3 + 1) (7 15) (1 ) (b )) ; if S > S (7 15)(1 )(b ) 16(3+1) ; S S max b++(3b 10) 15 (b ) 16(3+1) < 0; 3 (S (19 3) (1 ) (b )) if S > S S S max (1 )(b ) (19 3) ; 1+1b (b+5) (19 3) < 0 3 case I. S S min 4b+1, min( ) and min( 3 ) for S min, as (9(b+3) (b+11))4min 34b 4( 3b+3b 1)+4 (64b+7)(b ) 16 ; if < 1 case II. S S max b+1, max( ) and max( 3 ) for S max, as 3 and 3 and (3 (6b + 7) (b + 5)) max 9 (3b + ) 6 3b + b + (16b + 13) (b ) ; if < 1 ( ) (1 ) ; with 1 (S (1 3) + (1 ) (5b 1)) ; (1 ) (5b 1) (b ) ; 3 S S (3 + 1) b + (10b 11) 3 (7b 5) ( ) 1 (S (1 3) + (1 ) (5b 1)) ; 1 (1 ) (5b 1) (b ) ; 3 S S (3 + 1) b + (10b 11) 3 (7b 5) ; 3 S S min 4b+1, min( 1 ) and min( 3 ) for S min, as 1 3 and b+3( 1) 44b+56b (13b+1)(b 7)+4 min (9b (17b+)) 4 ( ) 0

22 q (1 ) ; with 1 (1 ) (b ) ; S (3 + 1) ; 3 q < 0 q q q Increase in Government Enforcement s with 1 S (3S + b ) ; (b ) ; 3 (b ) (1 ) : s < 0 1 S (3S + b ), 1 (b ) ; ; 3 (b ) (1 ) ; ; S S min 4b+1, min( 1 ) and min( ) for S min, as b 141 1(b 1)+16b (+3)+3(b ) min 3 ; if < 1 s < 0 and , with 54(1 ) 1 (1 ) (b + 5) (b ) (S (1 ) (b )), (1 ) (b + 5) (b ) + 16S ; 3 S (1 ) (10b (b + 5)) ; 4 S 3 (3 + 5) : 1 (1 ) (b + 5) (b ) (S (1 ) (b )), 1 (1 ) (b + 5) (b ) + 16S, 3 S (1 ) (10b (b + 5)), if < 10b+7 6b+15, 3 4 S 3 (3 + 5), 4 case I. S S min 4b+1, min( 1 ); min( ), min( 3 ) and min( 4 ) for S min, as 1, 3 4, and (7 47)+4b(b+)+16 (b ) (3(4b+b 13) 4(b+5)(b )( )) (b+16b 53) 9(164b+0b +64b 3 457) 64 + (b+5)(35b 16b 397)+64 3 (b+5)(b ) 64 case II. S S max b+1 3,, max( 1); max( ), max( 3 ) and max( 4 ) for S max, as 1, 4 and

23 9(1 )+3b(b+4)+ (b ) (3(b+)(b 1) (b+5)(b )( )) 7) + +9(b 6(19b+17b +3b 3 ) (b+5)( b+b +5)+ 3 (b+5)(b ) , with 54( 1) 1 (1 ) (b ) (S (1 ) (b )), 3S 5 (1 ) (b ), 3 S (7 15) (1 ) (b ), 4 16S 3 (3 + 5) < 0 if b & 1:7 1 (1 ) (b ) (S (1 ) (b )), 1 3S 5 (1 ) (b ), 3 S (7 15) (1 ) (b ), S 3 (3 + 5), 4 case I. S S min 4b+1, min( 1 ); min( ), min( 3 ) and min( 4 ) for S min, as 1, 3 4, and (37b 16b 4b 3 31)+(b+5)(3b 64b 157)+ (b )(44b+176b 35) (b ) 3 4 3(7 47)+4b(b+)+16 (b ) (3(16b+b 13)+10(b ) ( )) 3 if b & 1:7 case II. S S max b+1, max( 1); max( ), max( 3 ) and max( 4 ) for S max, as 1 3 4, and, (5b+b +9b 3 +10)+ (b+4)( b+4b +1)+ (b )(5b+11b 13) + 3 (b ) 3 9(1 )+3b(b+4)+ (b ) (3(1b+b 4)+5(b ) ( )) < 0 if b & 1:7 q 1 3 4S 9( 1) with 1 S (3 + 5) ; ; 3 (1 ) (b ) 1 S (3 + 5) ; 1 ; 3 (1 ) (b ) ;if b > if b & 1:5 case I S S min 4b+1, min( 1 ) and min( ) for S min, as 1,, 1 3 3(4b+7)+(0b 13) 16min ; if < 1 case II. S S max b+1, max( 1) and max( ), as 1, 1 3 3(b+3)+(5b 1) 4max