A theory of quality‐related differences in retail margins: why there is a ‘premium’ on premium gasoline

This paper develops a theory of vertical and horizontal product differentiation to explain observed price‐cost margin differentials for goods that differ in quality. The difference in price‐cost margins between the high‐ and low‐quality goods is shown to depend positively on consumers' average valuation for incremental increases in quality and positively on the distance to each competitor's closest rival. These predictions are largely supported using an extensive station‐level data set of premium and regular unleaded gasoline prices from the Los Angeles Basin area from 1992–1995.