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Abstract: In vertically differentiated markets, the effects of firm entry are contingent upon whether incumbent firms can respond to entry by adjusting product quality in addition to simply lowering prices. Using market-level data, I estimate a structural model of supply and demand for subscription television that takes into account the endogeneity of quality choice. Using counterfactual analysis, I decompose the effect of satellite entry on existing cable into two components: the conventional price response and the effect of endogenous quality adjustments (measured by changes in programming content). Consistent with the empirical observation that cable prices rose during the 1990s and early 2000s "in spite of" increasing competition, I find that raising both price and quality for the most comprehensive subscription package--i.e., competing "head-to-head"--is the rational response to entry by cable systems in markets with relatively homogeneous consumer types. Elsewhere, incumbents respond less aggressively and relegate themselves to being the low-end provider. When an entrant credibly commits to serving consumers with the highest preferences for quality, competition over both price and quality lowers the welfare gains due to entry, relative to pure price competition. In particular, head-to-head competition results in "crowding" of quality choices toward the high end of the market and inefficiently low product differentiation. In such cases, consumers with weak quality preferences may actually become worse off following entry. The evidence also suggests that the observed degradation of the lowest-quality cable tier in many markets during this time period--while commonly seen as an attempt to evade price regulation--may actually have been welfare-enhancing.

Keywords: Entry, endogenous quality, vertical differentiation, bundling

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