Location and Quality Competition with Endogenous Vertical Differentiation

This paper studies a two-firm competition model in which before competing in prices, firms choose both product locations and quality levels. After the price competition stage, the firms’ payoff functions are highly nonlinear and include interactions between location and quality choices. Despite this complexity, the game has a unique equilibrium. The equilibrium is robust to whether firms choose location and quality simultaneously or sequentially. In equilibrium, both firms locate symmetrically, one firm provides the highest possible quality, and the other firm chooses an interior quality level. The analysis shows that vertical differentiation can arise endogenously even when firms are ex ante symmetric and face no cost asymmetries.