Price, Quality and Quantity Regulation in Monopoly Situations

Economists now have at their disposal a well-developed body of analysis dealing with price and quantity behaviour in various market structures, but they have no comparable body of analysis relating to the qualitative and alterable attributes of products that consumers value. Product reliability, durability and availability of service facilities are examples of such quality attributes. In transportation, the frequency of travel, its safety, speed, space provision and aesthetic aspects of design are all examples of quality variations whose supply is costly and determined by the firm. The objects of this paper are the following: first, to develop a model of the socially optimum levels of quality and quantity; second, to use the model to demonstrate how quality and quantity levels are simultaneously chosen by a monopoly firm, and analyse in what direction the monopoly equilibrium deviates from the social optimum; finally, to determine the effects of various regulatory policies on the monopoly's decisions, and thereby to examine the desirability of such measures. The paper uses notions of consumer's surplus to characterize the social optimum. The use of consumer's surplus can be rigorously justified by assuming that all consumers are identical and have separable utility functions, U, linear in other commodities, y: U=u (x, q)? +y, with ux>O and u, <0, where x is the quantity and q an index of quality. The first-order condition for utilitymaximum subject to a budget constraint px + y =n, where p is the price of x (price of y normalized to be unity) and in income, is ux (x, q) <p and xu, (x, q) p =0. Thus, p = u, (x, q) is the inverse demand function and, accordingly,