Quality Innovation with Variable Demand Elasticity

Abstract I study product-quality innovation under monopolistic competition with variable demand elasticity preferences and general cost functions. I characterize the free-entry equilibrium and the effects of market size, marginal production cost, and fixed cost on equilibrium product quality and markups. Then I show how these results change with a small number of firms that engage in competitive interaction a-la Cournot. Overall, for the commonly assumed demand and cost structures, an increase in market size or marginal production cost works to decrease markups and increase product quality, while markups increase along with product quality due to an increase in fixed (entry) cost.