CARTEL STABILITY UNDER QUALITY DIFFERENTIATION

IWAN BOS AND MARCO A. MARINI

Abstract. This note considers cartel stability when the cartelized products are vertically
di¤erentiated. If market shares are maintained at pre-collusive levels, then the …rm with
the lowest competitive price-cost margin has the strongest incentive to deviate from the
collusive agreement. The lowest-quality supplier has the tightest incentive constraint when
the di¤erence in unit production costs is su¢ ciently small.

Keywords: Cartel Stability, Collusion, Vertical Di¤ erentiation.

JEL Classi…cation: D43, L13, L41.

1. Introduction
In this note, we examine cartel stability when the cartelized products are vertically dif-
ferentiated. Goods or services are di¤erentiated vertically when there is consensus among
consumers about how to rank them quality-wise; comparing products A and B, all agree A
to have a higher (perceived) value than B or vice versa. There might, however, still be a
demand for lower-quality goods when buyers face budget constraints or di¤er in their will-
ingness to pay for quality. This creates an incentive for suppliers to compete through o¤ering
di¤erent price-quality combinations.
One implication of this price-quality dispersion is that …rms that consider colluding typ-
ically face heterogeneous incentive constraints. The fact that …rms are induced to charge
di¤erent prices, for example, a¤ects both collusive and noncollusive pro…ts. From a supply-
side perspective, there commonly exists a positive relationship between the quality of a good
and its production costs. This, too, impacts both sides of the constraint. It is therefore a
priori unclear how quality di¤erentiation impacts the sustainability of collusion.
The scarce literature on this topic provides mixed results and, moreover, does not con-
sider the potential impact of cost heterogeneity.1 Assuming identical costs, Häckner (1994)
and Symeonidis (1999) both analyze an in…nitely repeated vertically di¤erentiated duopoly
game.2 Häckner (1994) studies a variation of the setting in Gabszewicz and Thisse (1979)
Date: October 2018.
We appreciate the comments of Maria Rosa Battaggion, Boris Ginzburg, Joseph E. Harrington Jr., Ronald
Peeters, an anonymous referee, participants at the 2018 Oligo Workshop and the 2018 EARIE conference in
Athens. All opinions and errors are ours alone.
Iwan Bos, Department of Organization & Strategy, School of Business and Economics, Maastricht University.
E-mail: i.bos@maastrichtuniversity.nl.
Marco A. Marini, Department of Social and Economic Sciences, University of Rome La Sapienza. E-mail:
marini@dis.uniroma1.it.
1
An extensive and detailed overview of this literature is provided by Marini (2018).
2
Apart from being analytically convenient, the identical cost assumption can be defended on the grounds
that the di¤erence in quality may mainly come from upfront sunk investments in which case the impact on
prices would be limited.
1

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2 IWAN BOS AND MARCO A. MARINI

and Shaked and Sutton (1982) and …nds that it is the high-quality supplier who has the
strongest incentive to deviate. By contrast, Symeonidis (1999) considers a representative
consumer model with horizontal and vertical product di¤erentiation and establishes that it
is the low-quality seller who is most eager to leave the cartel.
In the following, we analyze an n-…rm in…nitely repeated game version of the classic vertical
di¤erentiation model of Mussa and Rosen (1978) where production costs are assumed to be
increasing in quality.3 Under the assumption that colluding …rms maintain their pre-collusive
market shares, we …nd that it is the competitive mark-up rather than the quality of the
product that drives the incentive to deviate. Speci…cally, it is the supplier with the lowest
noncooperative price-cost margin who has the strongest incentive to chisel on the cartel.
Moreover, our analysis con…rms the above-mentioned conclusion by Symeonidis (1999) when
the di¤erence in unit costs is su¢ ciently small.
The next section presents the model. Section 3 contains the main …nding. Section 4
concludes.

2. Model
There is a given set of suppliers, denoted N = f1; : : : ; ng, who repeatedly interact over
an in…nite, discrete time horizon. In every period t 2 N, they simultaneously make price
decisions with the aim to maximize the expected discounted sum of their pro…t stream.
Firms face a common discount factor 2 (0; 1) and all prices set up until t 1 are assumed
public knowledge.
Each …rm i 2 N sells a single variant of the product with quality vi . We assume 1 >
vn > vn 1 > ::: > v1 > 0 and refer to …rm n as the top …rm, …rm 1 as the bottom …rm
and all others as intermediate …rms. Unit production costs of …rm i 2 N are given by the
constant ci and we suppose these costs to be positive and (weakly) increasing in quality, i.e.,
cn cn 1 : : : c1 > 0.
Consumers have a valuation for the various product types of , which is uniformly distrib-
uted on a unitary interval [ ; ] R++ . A higher corresponds to a higher gross utility when
consuming variant vi . Buyers purchase no more than one item so that someone ‘located’at
obtains the following utility

vi pi when buying from …rm i

(2.1) U( ) =
0 when not buying,

where pi 2 0; vn is the price set by …rm i.4 Using (2.1), it can be easily veri…ed that a
consumer at i 2 [ ; ] is indi¤erent between buying from, say, …rm i + 1 and …rm i when

pi+1 pi
(2.2) i (pi ; pi+1 ) = ;
vi+1 vi

3 Like
the model in Häckner (1994), this is a model with heterogeneous customers. Apart from the number
of …rms and cost heterogeneity, it di¤ers in terms of consumers’utility speci…cation.
4 Note that none of the buyers would buy at prices in excess of v .
n

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 CARTEL STABILITY UNDER QUALITY DIFFERENTIATION 3

for every i = 1; 2; :::; n 1. In the ensuing analysis, we further assume that the market is
and remains covered (i.e., all consumers buy a product).5
Current pro…t of the bottom …rm (i = 1) is therefore given by
(2.3) 1 (p1 ; p2 ) = (p1 c1 ) ( 1 );
where 1 = 1 (p1 ; p2 ) is as speci…ed by (2.2). For each intermediate …rm (i = 2; 3; :::; n 1)
pro…t is
(2.4) i (pi 1 ; pi ; pi+1 ) = (pi ci ) ( i i 1) ;

and for the top …rm (i = n) it is

(2.5) n (pn 1 ; pn ) = (pn cn ) n 1 :
Before analyzing the in…nitely repeated version of the above game, let us …rst consider
the one-shot case in more detail. In this setting, each …rm simultaneously picks a price to
maximize its pro…t as speci…ed in (2.3)-(2.5). Following the …rst-order conditions, this yields
three types of best-response functions:

1
(2.6) pb1 (p2 ) =
(p2 + c1 (v2 v1 ))
2
for the bottom …rm (i = 1). For each intermediate …rm (i = 2; 3; :::; n 1), the best-reply is
given by

1 pi 1 (vi+1 vi ) + pi+1 (vi vi 1 ) 1

(2.7) pbi (pi 1 ; pi+1 ) = + ci :
2 (vi+1 vi 1 ) 2
The best-response function of the top …rm (i = n) is
1
(2.8) pbn (pn 1 ) = pn 1 + cn + (vn vn 1 ) :
2
Since the action sets are compact and convex and the above best-reply functions are con-
tractions, there exists a unique static Nash equilibrium price vector p for any …nite number
of …rms.6 Finally, we impose two more conditions to ensure that the equilibrium solution is
interior (i.e., all …rms have a positive output at p ) and that the market is indeed covered
at the single-shot Nash equilibrium:
p
(2.9) > n 1 > n 2 > : : : > i > ::: > 1 > > 1 > 0;
v1
5 This is a common assumption in contributions that employ this type of spatial setting. See, for exam-
ple, Tirole (1988, pp. 296-298) and Ecchia and Lambertini (1997). We discuss some implications of this
assumption at the end of Section 3 and in an online appendix.
6 See, for instance, Friedman (1991, p.84). A su¢ cient condition for the contraction property to hold is
(see, for example, Vives 2000, p.47):
@2 i P @2 i
2 + < 0;
@ (pi ) j6=i @pi @pj
which, using (2.4) for all intermediate …rms i = 2; :::; n 1, becomes
vi 1 vi+1
< 0;
(vi+1 vi ) (vi vi 1 )
which holds. The same applies for the top and the bottom …rm.

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4 IWAN BOS AND MARCO A. MARINI

where i i pi ; pi+1 and pi ci , for all i 2 N .

3. Sustainability of Collusion
Within the above framework, we now study the sustainability of collusion assuming a
standard grim-trigger punishment strategy. The incentive compatibility constraint (ICC) of
a …rm i 2 N is then given by:

c d
(3.1) i i (1 ) i i 0;
where ci = i pci 1 ; pci ; pci+1 is its collusive payo¤, di = i pci 1 ; pdi ; pci+1 , with pdi =
pbi (pci 1 ; pci+1 ), is its deviation payo¤ and i = i pi 1 ; pi ; pi+1 is its Nash equilibrium payo¤.
A cartel comprising the entire industry is thus sustainable only when i 0 for all i 2 N .
In principle, this set-up allows for a plethora of sustainable collusive contracts. In the fol-
lowing, we limit ourselves to what is perhaps the simplest possible agreement. Speci…cally,
we consider the maximization of total cartel pro…ts without side payments under the as-
sumption that …rms maintain their market shares at pre-collusive levels. Such an agreement
is appealing for several reasons. First, it seems a natural focal point in the issue of how
to divide the market. Second, there have been quite a few cartels that employed such (or
similar) market-sharing scheme.7 Third, it is arguably one of the most subtle arrangements
in that …rm behavior maintains a competitive appearance, thereby minimizing the possibility
of cartel detection.
Let us now address the question of what collusive price vector such an all-inclusive cartel
would pick. As an initial observation, notice that the …xed market share assumption implies
that the price ranking should stay the same (i.e., collusive prices are strictly increasing in
quality). Moreover, as market size is given, the lowest-valuation buyer should still be willing
to buy the product. This means that

v1 pc1 0:
The …xed market share rule then dictates that each ‘marginal consumer’s location’remains
una¤ected. Speci…cally, the consumer who was indi¤erent between …rm 1 and 2 absent
collusion has now the following utility when buying from …rm 1:
p2 p1
U ( 1) = v1 pc1 ;
v2 v1
which in turn determines the collusive price for the product of …rm 2:
p2 p1 p2 p1
v1 pc1 = v2 pc2 :
v2 v1 v2 v1
Rearranging gives,
pc2 = p2 + (pc1 p1 ) :
A higher collusive price by …rm 2 would mean that the customer on the boundary prefers …rm
1, which contradicts market shares being …xed. Likewise, a lower price implies a decrease
in sales for …rm 1 and therefore cannot occur either. The collusive prices for all other …rms
7 See, for example, Harrington (2006).

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 CARTEL STABILITY UNDER QUALITY DIFFERENTIATION 5

can be determined in a similar fashion. In general, the collusive price of …rm i 2 N nf1g is
equal to its Nash price plus the price increase by the lowest-quality …rm:
(3.2) pci = pi + (pc1 p1 ) :
Both cartel pro…ts and the incentive constraints are therefore e¤ectively a function of pc1
alone.
Since prices are strategic complements, it is clear that the cartel would like to set pc1 = v1 .
The collusive contract with pc1 = v1 might not be sustainable, however, because one or
more ICC’s may be binding. The next result shows that it is the supplier with the lowest
noncollusive pro…t margin who has the tightest incentive constraint.
Proposition 1. For any i; j 2 N and j 6= i, if pi ci > p j cj , then i > j.

Proof. Consider the ICC of an intermediate …rm i = 2; 3; :::; n 1:

d c
c d i i
i i (1 ) i i 0, i d
:
i i

To evaluate the critical discount factor i of every intermediate …rm, let us focus on
d c
i, i and i in turn. Every …rm’s i = 2; 3; :::; n 1 deviating pro…t is given by di =
d d
pdi ci i i 1 , which, using best-replies (2.7), yields

pci 1 (vi+1 vi ) + pci+1 (vi vi 1 ) (vi+1 vi 1 )ci

pdi ci =
2(vi+1 vi 1 )
implying
(3.3) 2(vi+1 vi 1 ) pdi ci = pci 1 (vi+1 vi ) + pci+1 (vi vi 1 ) (vi+1 vi 1 )ci :

Moreover,
d d (vi vi 1 ) pci+1 + (vi+1 vi ) pci 1 (vi+1 vi 1 ) ci
i i 1 = ;
2 (vi+1 vi ) (vi vi 1 )
from which
(3.4)
d d
2 (vi+1 vi ) (vi vi 1 ) i i 1 = (vi vi 1 ) pci+1 + (vi+1 vi ) pci 1 (vi+1 vi 1 ) ci :

Combining (3.3)-(3.4) yields

d d
2(vi+1 vi 1 ) pdi ci = 2 (vi+1 vi ) (vi vi 1 ) i i 1

and therefore
d (vi+1 vi 1 )
d
i i 1 pdi
= ci :
(vi+1 vi ) (vi vi 1 )
Hence, deviating pro…ts can be written as
d 2 (vi+1 vi 1 )
(3.5) i = pdi ci :
(vi+1 vi ) (vi vi 1 )
In a similar vein, intermediate …rms’Nash pro…t can be written as

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6 IWAN BOS AND MARCO A. MARINI

(vi+1 vi 1 )
(3.6) i = (pi ci )2 :
(vi+1 vi ) (vi vi 1 )
Following the covered market assumption, we know that
c c
i i 1 = i i 1

and
pci = pi + pc1 p1 :
Hence, every intermediate …rm’s collusive pro…t can be written as

c c c (vi+1 vi 1 )
(3.7) i = (pci ci ) i i 1 = (pi + pc1 p1 ci ) (p ci ) :
(vi+1 vi ) (vi vi 1 ) i

Note further that

(vi vi 1 ) pci+1 + (vi+1 vi ) pci 1 + (vi+1 vi 1 ) ci
pdi =
2 (vi+1 vi 1 )
(vi vi 1 ) pi+1 + pc1 p1 + (vi+1 vi ) pi 1 + pc1 p1 + (vi+1 vi 1 ) ci
=
2 (vi+1 vi 1 )
1
= pi + (pc1 p1 ) :
2
Combining (3.5)-(3.7) yields
(vi+1 vi 1 ) 1 c
(3.8) d
i
c
i = (p p1 )2 ;
(vi+1 vi ) (vi vi 1 ) 4 1
and

d (vi+1 vi 1 ) 1 c
(3.9) i i = (pc1 p1 ) (p p1 ) + (pi ci ) :
(vi+1 vi ) (vi vi 1 ) 4 1
Thus, by (3.8) and (3.9), the critical discount factor of every intermediate …rm i = 2; 3; :::; n
1 is given by
1
d
i
c
i 4
(pc1 p1 )
i d
= 1 ;
i i 4
(pc1 p1 ) + (pi ci )
which is decreasing in the noncollusive price-cost margin.
Turning to the top-quality …rm, by following the above steps, it can be veri…ed that
2
d pdn cn (pn cn )2
n = ; n = and
(vn vn 1 ) (vn vn 1 )
!
c (vn vn 1 ) pn pn 1
n = (pc1 p1 + pn cn ) ;
vn vn 1
yielding
1
d
n
c
n 4
(pc1 p1 )
n = 1 :
d
n n 4
(pc1 p1 ) + (pn cn )

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 CARTEL STABILITY UNDER QUALITY DIFFERENTIATION 7

Hence, it is the supplier with the smaller noncooperative price-cost margin (between …rm
n and …rm n 1) who has the tighter incentive constraint. The same can be shown to hold
for the two lowest-quality …rms: p2 c2 > p1 c1 implies 2 > 1 , whereas p1 c1 > p2 c2
implies 1 > 2 . We thus conclude that, if pi ci > pj cj , then i > j for all i; j 2 N;
j 6= i.
The incentive to deviate from the collusive agreement is determined by the short-term
gain of defection di c
i and the severity of the resulting punishment ( i
d
i = i
d c
i+
c
i i ). The proof of Proposition 1 reveals that the ‘extra pro…t e¤ect’is the same across
…rms and that the heterogeneity in incentive constraints is exclusively driven by di¤erences
in the punishment impact ( ci i ). Speci…cally, there is a positive relation between a …rm’s
market share and its noncollusive price-cost margin. Since market shares are …xed at pre-
collusive levels, members with a higher competitive mark-up are hit relatively harder by a
cartel breakdown and this creates a stronger incentive to abide by the agreement.
The next result follows immediately. In stating this result, let 4cij = ci cj for any …rm
i; j 2 N and j 6= i.
Corollary 1. For any …rm i; j 2 N and j 6= i, 9 2 R++ such that if 4cij < and vi > vj ,
then i > j .
Hence, if the di¤erence in unit production costs is su¢ ciently small, then it is the lowest-
quality supplier who has the tightest incentive constraint. Our analysis thus con…rms the
above-mentioned conclusion by Symeonidis (1999) in case quality heterogeneity is primarily
driven by (sunk) …xed costs rather than variable costs.8
Let us conclude this section with a remark on the covered market assumption. Note
that since each ICC is strictly concave in the own cartel price, a su¢ cient condition for the
cartel to keep market size constant is that at pc1 = v1 , i 0 and @@pci < 0 for all i 2 N .
i
Endogenizing the size of the market would therefore not a¤ect the above …ndings when the
discount factor is su¢ ciently low. If its members are patient enough, however, then the
cartel would like to uncover the market. This case is generally far less tractable analytically,
but we show in an online appendix that this paper’s results also hold when the number of
low-valuation buyers leaving the market is su¢ ciently small.

4. Conclusion
Many markets are characterized by some degree of quality di¤erentiation with correspond-
ing …rm heterogeneity in cost and demand. One implication of such di¤erences is that collud-
ing …rms typically face non-identical incentive constraints. Existing literature on this topic
focuses on demand di¤erences, while ignoring the potential impact of cost heterogeneity.
In this note, we considered how cartel stability is a¤ected when unit costs are increasing in
product quality. Under the assumption that colluding …rms maintain their pre-collusive mar-
ket shares, we found that the incentive to deviate from the collusive agreement is monotonic
in the noncollusive price-cost margin. Speci…cally, the supplier with the lowest competitive
mark-up is ceteris paribus most inclined to leave the cartel. Moreover, it is the lowest-quality
seller who has the tightest incentive constraint when di¤erences in unit costs are su¢ ciently
small.

8 This result can also be shown to hold in an n-…rm variation of the model in Häckner (1994). The analysis
is available upon request.

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8 IWAN BOS AND MARCO A. MARINI

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