SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: We study an asymmetric information model in which two firms are active on a market where buyers only observe the average quality supplied. Quantities and cost structures are exogenously given and firms compete in quality. Before choosing their qualities, they bargain over a perfectly enforcable minimum quality standard. The bargaining outcome is given by the Kalai-Smorodinsky (KS) solution. Agreement on a binding standard is possible only if the firms are sufficiently similar with respect to their production costs. The agreed-upon standard always falls short of the joint-profit-maximizing (or, for that matter, the efficient) level. It is decreasing in the high-cost producer's cost of production. Yet, it first increases then decreases with the low-cost producer's cost of production, showing that the latter's bargaining position can be enhanced by seemingly adverse cost changes.

Keywords: asymmetric information; minimum quality standard; duopoly; bargaining; free riding.

JEL-codes: D43; D82; L13; L15

38 pages, First version: December 30, 2005. Revised: May 8, 2006. Earlier revisions: January 18, 2006, May 8, 2006, May 8, 2006, May 8, 2006.

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