Regulating quality by regulating quantity: a case against minimum quality standards

We show in a simple model of entry with sunk cost, that a regulator is best advised to limit the output or capacity of the incumbent firm rather than impose a general Minimum Quality Standard in order to maximize industry welfare. The quota amounts to protect the entrant (or low quality firm) from price competition. As a consequence it becomes more profitable to sink money into quality upgrades. As a by-product, our analysis makes a contribution to the study of Bertrand-Edgeworth competition in a market with differentiated products that extends and confirms Krishna (1989) for our particular model of duopolistic competition