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Abstract

An analytical model is developed to examine product quality labeling. Prior to labeling all consumers are willing to pay a premium for the quality characteristic but product quality cannot be observed directly. If production costs are increasing, the total quantity produced may contain a mix of products - with and without the high-valued attribute. In the pooled equilibrium demand is influenced by perceptions of the product mix. After labels are introduced the market is separated into two sectors, conventional and high-valued. The economic implications of labels are examined by contrasting welfare in the separating equilibrium with welfare in the pooled equilibrium. Under the models' maintained assumptions the conventional sector loses welfare, while producers of the high-valued product experience gains. In addition, producers of the high-valued product may have incentives to promote costly labeling despite net-welfare losses.

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