1. Lectures in Microeconomics-Charles W. Upton The Keith-Leffler Model

2. The Problem Suppose it costs $10 to make a high quality product. Competition will force the price to $10. Hence –If you can make a low quality product for $5 and pass if off you can make money until caught. –But there is no reward for making a high quality product.

3. The Keith-Leffler Model Assumptions Two levels of quality, q high and q min.

4. The Keith-Leffler Model Assumptions Two levels of quality, q high and q min. Higher quality products cost more to produce. The cost function is C(X,q high ) or C(X,q min ).

5. The Keith-Leffler Model More Assumptions The public cannot tell in advance whether a firm produces a high quality or a low quality product, but can after a year.

6. The Keith-Leffler Model More Assumptions The public cannot tell in advance whether a firm produces a high quality or a low quality product, but can after a year. Consumers know - don’t ask how - the minimum cost of producing both q high and q min.

7. The Keith-Leffler Model Produce High or Low Quality? AC(X,q min ) MC(X,q min )

8. The Keith-Leffler Model Produce High or Low Quality? AC(X,q min ) AC(X,q high ) MC(X,q min ) MC(X,q high )

9. The Keith-Leffler Model Three Strategies Be honest. Produce a low quality product and sell it at the low price. Be honest. Produce a high quality product and sell it at the high price.

10. The Keith-Leffler Model Three Strategies Be honest. Produce a low quality product and sell it at the low price. Be honest. Produce a high quality product and sell it at the high price. Cheat. Produce a low quality product, label it a high quality product and sell for a year at the high price.

11. The Keith-Leffler Model Profits Be honest. Produce a low quality product and sell it at the low price.  = 0 Be honest. Produce a high quality product and sell it a the high price.  = 0 Cheat. Produce a low quality product, label it a high quality product and sell for a year at the high price. Let’s see

12. The Keith-Leffler Model Produce High or Low Quality? AC(X,q min ) AC(X,q high ) MC(X,q min ) MC(X,q high )

13. The Keith-Leffler Model Produce High or Low Quality? P P

14. The Keith-Leffler Model Produce High or Low Quality? Optimal production for low quality product P P

15. The Keith-Leffler Model Produce High or Low Quality? Optimal production for low quality product ππ

16. The Keith-Leffler Model Produce High or Low Quality? Extra production due to spurious higher price ππ

17. The Keith-Leffler Model Produce High or Low Quality? Extra production due to spurious higher price π1π1  π 2

18. The Keith-Leffler Model Produce High or Low Quality? π1π1 π2π2 Honesty  =0 Cheating   =(  π 1 +  π 2 )/(1+r)

19. The Keith-Leffler Model Produce High or Low Quality? π1π1 π2π2 Honesty may be its own reward but not here

20. The Keith-Leffler Model The Incentive for Honesty π1π1 π2π2 Now suppose there is a premium for honesty P*

21. The Keith-Leffler Model The Incentive for Honesty π1π1 π2π2 The honest firm produces here P*

22. The Keith-Leffler Model The Incentive for Honesty Its profit is the area A P* A

23. The Keith-Leffler Model The Dishonest Firm Does More P*

24. The Keith-Leffler Model Its Profits P* A B D C

25. The Keith-Leffler Model Its Profits P* A B D C B+C Profits from cheating

26. The Keith-Leffler Model Its Profits P* A B D C A Profits from the premium for honesty

27. The Keith-Leffler Model Its Profits P* A B D C D Profits form cheating on the premium for honesty

28. The Keith-Leffler Model The Difference P* A B D C The Cheat earns A +B+C+D once

29. The Keith-Leffler Model The Difference P* A B D C The Cheat earns A +B+C+D once The Honest Firm earns A again and again

30. The Keith-Leffler Model To Cheat or Not to Cheat P* A B D C The Cheat earns A +B+C+D once The Honest Firm earns A again and again

31. The Keith-Leffler Model End ©2004 Charles W. Upton