Often a firm is confronted with the key question of whether the quality of the firm’s products and services should be improved. For many readers, the question may even seem illogical – how could it not be beneficial for a firm to improve the quality of its products and services?
On closer analysis, however, the question has deep strategic implications because ultimately a firm’s market structure and competition influence its choice of quality. Incurring additional costs to provide a level of quality that is neither valued by consumers nor provides sufficient differentiation from the competition may be unwise in the long run.
In trying to determine an appropriate level of quality, there are several factors which relate to a firm’s underlying economics. First, we want to know what increase in demand for a product or service is likely to result if quality is improved. Secondly, we would want to know how the firm’s profitability might be impacted from the increase in demand. This is related to the incremental or marginal profit earned on each additional unit sold.
Answering the first question requires a firm to have knowledge of its demand curve and the degree to which improvements in quality would appeal to its marginal customers. It has been pointed out by Michael Spence and others that, when considering an increase in quality, firms should ignore their “infra-marginal” customers – those customers loyal to the firm and who will continue to transact business with the firm, whether or not it makes improvements in quality. Rather, the firm should focus on its marginal customers – those buyers in the marketplace who have so far been indifferent to buying from the firm, and whose buying choice might be influenced by an improvement in quality. Two things can happen to a firm’s demand curve when quality is improved. Firstly, as explained above, the demand for the firm’s product and services can be increased. That is, the firm may be able to sell more of its product at a given price when it raises quality. Secondly, the firm’s demand becomes more price inelastic, reflected in a steeper slope of the demand curve. This occurs because the firm will tend to capture those marginal customers who value the improved quality, and who will be prepared to pay more for it, if necessary.
The change in price elasticity which can result from improved quality is very important and is often overlooked by firms. When improving quality, a firm may also want to consider the impact that quality improvement has on the willingness of buyers to substitute other products – the marginal rate of substitution. The marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of satisfaction. As a firm supplies greater quality, buyers will be less inclined to trade-off value in favour of poorer quality and less expensive alternatives available from competitors.
Modeling the impact upon demand that results from increased quality can yield valuable insights into the revenue gains that might result. Such an analysis should not be undertaken in isolation from the industry or competitive environment in which the firm resides. In our practice, we always extend such a demand-impact analysis with analyses of the firm’s industry structure and the nature of its competition, since these are the ultimate determinants of profitability.
We also extend this analysis by creating a value map (diagram below) which shows the placement of a firm’s key competitors with respect to product quality. The indifference curve shows the price-quality combinations which yield the same value surplus for buyers. Price-quality positions located below the indifference curve yield a higher value surplus than positions located above the curve.
In the above value map, the price-quality positions of products (A, B, C and D) from four competitive firms are plotted. In addition, an indifference curve is also plotted showing the boundary at which buyers become indifferent to various combinations of price and quality, and hence show no preference for one product over another. In the map, the firm producing product A is likely to lose business as its product is offering buyers a low value surplus due to the low quality coupled with the high price. In contrast, the firm producing product D is likely to gain business as it is offering buyers a high value surplus due to the high quality coupled with the low price. The firms producing products B and C both lie on the curve of indifference and, as such, are offering buyers the same amount of value surplus. These firms have achieved value surplus parity, although they will still likely lose business to the firm producing product D as it is offering a higher value surplus.
The choice of quality levels should also be rationalized by considering the marginal profit earned on each additional unit sold which results from an increase in quality. Most firms are familiar with the basic economic impact that results from undertaking improvements which reduce scrap, rework and warranty claims. Simply put, as quality improves, the average cost of production per unit falls, reflecting the cost reductions that result from less scrap, better yields, and less warranty repairs and replacements.
- Is your firm offering a higher or lower value surplus relative to the preferences of buyers and competitive offerings? If your firm is offering a lower value surplus, or even achieving value parity, you may be losing business to any rival offering a higher value surplus. Your firm’s relative value surplus may be an indicator that a change in the product/service quality level is warranted.
- When contemplating raising the quality level of your firm’s products and services, consider the impact that such an increase will have on your firm’s demand. Consider especially whether an increase in quality levels will increase the rate at which your firm attracts marginal customers.
- Increasing the quality level of a product or service may reduce the costs associated with scrap, rework and in-warranty repair. However, providing a higher quality level may also increase costs if new technologies or production methods are required. Recognize that quality is not always free!
- Due to points 2 and 3 above, determining an optimal quality level that maximizes profit is, essentially, a constrained optimization problem where the impacts on both costs and revenue must be considered together. Choosing quality levels based on either costs or revenue alone will not necessarily maximize profit.
 A.M. Spence, Monopoly, Quality and Regulation, Bell Journal of Economics, Autumn 1975