Proliferation and Entry Deterrence in Vertically Differentiated Markets

We examine the profitability, entry deterrence and welfare effects of proliferation offered by non-cooperative firms competing in quality and price. In a market of one high quality firm and competitive low quality firms, we find that the established high quality firm will not initiate proliferation but may have an incentive to do so if facing entry threats. The proliferation quality is endogenously determined and the industry profits decrease with such proliferation. Moreover, we show that proliferation increases consumer surplus in the same way as entry does. That is, while proliferation to deter entry is anti-competitive, it is not necessarily welfare-reducing.