International Journal of Industrial Organization

18 (2000) 575593
www.elsevier.com / locate / econbase

Workers skills, product quality and industry equilibrium

J. Gabszewicz a , *, A. Turrini a ,b
a

University of Louvain. CORE, 34 Voie du Roman Pays, 1348 Louvain-la-Neuve, Belgium

b
University of Bergamo and Cespri-Bocconi, Milan, Italy
Received 22 September 1997; accepted 22 May 1998

Abstract
In this paper we develop a model of a vertically differentiated industry where the
production of higher quality goods needs a higher fraction of specialized labour. In the first
stage, firms choose the quality of their products, in the second, both good prices and skilled
workers wages are determined. We show that in duopoly, though supplying different
variants of the product, firms tend to cluster either at the bottom or at the top of the quality
ladder, depending on skilled labour availability. This switch in equilibrium qualities creates
a discontinuous behaviour for the wage rate of skilled workers. When the supply of skilled
labour is made endogenous, two equilibria are simultaneously possible: one with low-skill,
low-quality, the other with high-skill, high-quality. 2000 Elsevier Science B.V. All
rights reserved.
Keywords: Quality competition; Strategic effects; Endogenous market structure; Skills investments;
Multiple equilibria
JEL classification: D4; J24; L13; L15

1. Introduction
According to recent empirical investigations, the quality of products seems to be
significantly related to the degree of availability of skilled labour. Countries

* Corresponding author.
E-mail address: gabszewicz@core.ucl.ac.be (J. Gabszewicz)
0167-7187 / 00 / $ see front matter 2000 Elsevier Science B.V. All rights reserved.
PII: S0167-7187( 98 )00031-9

576

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

characterized by a high degree of labour qualification are in a position to

manufacture goods with higher average quality compared with countries with less
qualified labour, and tend to perform better in higher quality segments in vertical
intra-industry trade.1 A technical linkage from available skills to feasible quality is
easy to envisage. If skilled workers can do a better job, compared with unskilled,
firms employing a larger fraction of trained and educated labour will benefit from
a better working of the production process and will manage to supply goods of a
higher level of quality.
When skills availability is a key determinant of quality, the analysis of
industries or countries quality performance cannot ignore the mechanisms for
skills creation. In a market economy, the supply of skills is determined by private
incentives originating on the labour market. The demand for skilled labour, in turn,
depends on firms incentives on the product market. If firms find it to be
convenient to sell low-quality (high-quality) products, their demand for skilled
labour is low (high), and market wages for qualified workers do not (do) stimulate
an abundant supply of skills. It is clear, then, how a market linkage, going now
from quality to skills is this way created. Goods quality requires skilled labour, but
the incentives to invest in human capital are determined by firms quality choices.
This strategic complementarity between firms and workers decisions, and the
consequent coordination problems has been investigated in the macroeconomic
literature (Acemoglu, 1994; Snower, 1994; Redding, 1996). In these analyses
firms strategic interactions on the product market are not considered. Firms are
price takers and the choice of product quality is not affected by rivals choices.
Yet, strategic effects are not only part of reality. They may also be relevant for the
comprehension of the economic channels linking skills availability and the quality
of products supplied in given industries. One thing is just to say that, the higher
the amount of available skilled labour, the higher is the possibility of manufacturing high-quality goods. Another thing is to characterize the relationship between
the availability of skilled labour and the quality of products supplied at an industry
equilibrium where strategic effects matter. The comprehension of the economic
linkage between skills availability and product quality is, in turn, essential to
characterize an industry equilibrium where skills supply and quality choices are
simultaneously determined by market forces.
In this paper we take a first step towards the introduction of strategic effects into
the analysis of the relation between workers skills and product quality. In doing
that, we develop an illustrative example of industry equilibrium where product

1
For instance, it is well documented in cross country comparisons that countries less endowed with
vocational skills such as Britain tend to produce relatively low-quality goods in several industries
(Daly et al., 1985; Steedman and Wagner, 1987; Mason et al., 1996). As for studies relating
intra-industry trade, skills and quality, the reader is referred to the works by Courakis (1991); Webster
(1993); Oulton (1996).

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

577

qualities, product prices and wages are endogenously determined. Our approach
builds on two analytical tools developed earlier in related contexts. The first one is
a representation of the production process, proposed by Kremer (1993), in view of
linking the workforce skills to the quality of the output. The production process
consists of different tasks, each one of them requiring a single worker, and
describes skill interaction among them. The second analytical tool used in our
analysis is a model of oligopolistic interaction in vertically differentiated industries
(Gabszewicz and Thisse, 1979; Shaked and Sutton, 1983).
We show that, depending on the (exogenous) degree of availability of skilled
labour, strategic interaction leads to two possible equilibrium regimes. While
choosing different qualities firms either cluster at the bottom of the quality ladder,
or at the top. As expected, the first regime arises when skilled labour is scarce, the
second when abundant, thus confirming the empirical observations.
When the availability of skilled labour is not taken as exogenous, but follows
from an explicit treatment of human capital investment decisions, two equilibrium
values for the supply of skilled labour are simultaneously possible, inducing in
turn two possible industry equilibria: in one low-skill, low-quality, in the other
high-skill, high-quality are observed. A result similar to those presented in the
macroeconomic literature dealing with human capital accumulation and growth is
thus obtained at the level of a single industry. In our setting, multiple equilibria are
a consequence of firms strategic interaction that determine a jump in equilibrium
qualities after a threshold skilled labour supply. Factors that affect firms
interaction on the product market may then have relevant consequences for skill
supply and equilibrium qualities.
In the remainder of the paper, after the description of the model, the equilibrium
in quality and prices is solved assuming an exogenous supply of skilled labour.
Subsequently, the industry equilibrium is determined for the case in which the
supply of skilled labour is the result of investment decisions in productive skills.
The discussion of results follow.

2. The industry
The manufacturing of one unit of the good requires the performance of two
(symmetrical) tasks, with one unit of labour per task. Two different types of labour
can be hired by firms, skilled and unskilled. The degree of qualification of workers
is related to the probability of successfully executing a task. If one unit of skilled
labour is employed, the probability of having a correctly executed task equals 1
(perfect performance), while we denote by s, s [ (0,1), the probability of success
for unskilled workers. If the probability of success of labour employed in different
tasks is independent, the value of each unit of the good just equals the product of
skills (probabilities) employed in each task. The production function for one unit

578

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

of the good has thus the so-called O-Ring form (Kremer, 1993)2 . According as
both tasks are performed by a unit of skilled labour, a mixture of skilled and
unskilled labour, or by two units of unskilled labour, three quality levels (variants)
of the good are realized, u h , u m , ul , where:
u h 5 1, u m 5 s, ul 5 s 2 ,

(1)

Notice that this formulation allows for an unambiguous definition of quality and
leads to a natural determination of the support on which quality is defined (i.e.,
(0,1]). The quality level of variant i, u i , is assimilated to a joint probability of
having perfectly performed tasks, i.e., a fully reliable product.3 Observe also that
firms are bound to choose within a finite set of available quality levels which is
given by technology, a feature that have relevant implications for the characterization of the industry equilibrium.
Concerning demand for the product, it is expressed by a continuum of
heterogenous consumers, uniformly distributed, with density M, on [0,1], and
ranked in the same interval in decreasing order of their intensity of preferences for
quality, u. The (indirect) utility of buying a single unit of variant i, i5h, m, l, for
consumer u is expressed in units of a Hicksian composite commodity and is given
by:
U(u ) 5 R(u ) 1 (a 2 u )u i 2 pi .

(2)

In Eq. (2), R(u ) is the income earned by consumer u ; a, a .1 is a parameter

denoting the (common) marginal utility for quality; u i denotes the quality level of
variant i; u is a parameter measuring (inversely) the intensity of preferences for
quality i which is specific to consumer u ; finally, pi denotes the price of variant i.
Note that this representation of preferences over consumers population is a
version of the classical one presented by Mussa and Rosen (1978).
A couple of remarks are necessary to better understand the demand side of the
model. First, as it is traditionally done in models of vertical differentiation, it is
assumed that consumers, if they buy, buy one unit of a single variant, at the
exclusion of the others. Second, the mass M of consumers that are interested in the
good does not necessarily coincide with the whole population in the economy. We
then allow for the possibility that an even a large fraction of individuals derives
zero utility from the consumption of the good, so that, for them, a 50. Finally, we

The failure of the launching of the space shuttle was entirely due to the malfunctioning of a small
component, the O-Rings. This anecdote well conveys the idea that the probability of success of a
complex process is given by the joint probability of success of all its parts.
3
The multiplicative interaction between labour skills employed in different tasks causes product
quality to increase more than proportionally with higher shares of skilled labour employed. The
implications for income distribution of this property of the O-Ring production function have been
analyzed by Kremer (1993). This feature of the O-Ring has also implications for our results concerning
equilibrium market structure.

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

579

skip the analysis of income effects, and simply assume that each consumer u who
is interested in the good owns income R(u ) which is high enough to allow him to
buy each variant at the actual price.
As far as the labour market is concerned, it is assumed to be competitive, i.e.,
both workers and firms are assumed to be wage takers. The assumption of perfect
competition in the labour market is a natural starting point since it allows to
concentrate the analysis on strategic effects on the output market. We further
assume that labour skills are industry-specific, so that wages of specialized
workers are entirely determined by the demand generated within the industry.
Skilled workers wages, in this way, just reflect the relative scarcity of specialized
labour.
Workers are endowed with one unit of working time and inelastically supply all
their labour endowment. The mass of unskilled workers in the economy is
arbitrarily large and their wage equals their marginal productivity in the production
of the numeraire good produced under constant returns to scale, which is denoted
by r. Skilled workers are fully specialized in the production of the differentiated
good, so that their probability of correctly performing their tasks in this industry is
higher than for unskilled workers. By contrast, they have instead the same
productivity as unskilled workers if employed in the numeraire sector. The supply
of skilled labour available in the economy is denoted by L and the wage rate for
one unit of skilled labour by w. The supply of skilled labour is then perfectly
inelastic and equal to L whenever w>r and becomes perfectly elastic in
correspondence with w5r if w,r.
The unit production cost for variant i, c i , is easily derived as: c h 52w,
c m 5w1r, cl 52r. Firms are ex-ante perfectly symmetrical. They (simultaneously)
choose in the first stage which variant of the good to supply while in the second
stage they (simultaneously) fix the price of the chosen variant. The industry
equilibrium is thus the outcome of a two-stage game where, in the second stage,
not only prices and market shares are determined, but also the wage for skilled
workers. Also firms costs are therefore determined at equilibrium.
Consider the case of two potential producers. Since, by a well-known Bertrand
argument, firms never select in the first stage an identical variant, the analysis is
limited to selections of two different products. By convention, we denote any pair
of qualities, (h,m), (m,l), (h,l), by (1,2), where 1 refers to the higher quality
variant, 2 to the lower one. Assume that both firms are active on the market, i.e.,
both have positive demand and cover their marginal costs at a given pair of prices,
p1 and p2 . Given this pair of prices, we say that the market is covered when every
consumer buys a unit of some variant, and uncovered otherwise. Demands differ
according as the market is covered or not. In the first case, denoting by u1,2 the
consumer indifferent between buying product 1 at price p1 and product 2 at price
p2 , demand of firm 1 (resp. 2) is given by Mu1,2 (resp. M(12u1,2 )). In the
uncovered case, denoting by u2,0 , the consumer indifferent between buying product
2 at price p2 and not buying at all, demand of firm 1 is still given by Mu1,2 , while

580

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

demand of firm 2 now becomes M(u2,0 2u1,2 ). From the expression of consumers
p1 2 p2
utility (expression Eq. (2)) it is easily derived that u1,2 5 a 2 ]]
u 1 2 u 2 and u2,0 5 a 2
p2
2,
] . The highest price for the low quality good such that the market is covered, p
u2
is obtained as p 2 5u 2 (a 21).
At given costs c 1 , c 2 , firms profits are thus given by

p1 2 p2
p1 ( p1 , p2 ) 5 M a 2 ]] ( p1 2 c 1 ),
u1 2 u2

p1 > c 1 ;

(3)

for firm 1 and by

F S
F

DG
G

p1 2 p2
M 1 2 a 2 ]]
( p2 2 c 2 ),
u1 2 u2
p2 ( p1 , p2 ) 5
p1 2 p2 p2
M ]] 2 ] ( p2 2 c 2 ),
u1 2 u2 u2

p 2 > p2 > c 2 ;
(4)
p2 . p 2 > c 2

for firm 2, according as the market is covered or not.4 It is worth noting that profits
are continuous and concave in own price for firm 1, whereas firm 2 profits exhibit
a corner at p 2 and are piece-wise concave.5

3. Equilibrium analysis
In this section we are interested in deriving which qualities firms are willing to
choose at equilibrium, depending on the degree of availability of skilled labour in
the industry. The amount of skilled labour, L, determines, via the equality of
supply and demand, firms cost differentials at each quality configuration, and then
the corresponding equilibrium profits in the second stage, thus affecting the first
stage outcome. Though clear in principle, such analysis requires some introductory
remarks. First of all, since L determines relative costs, it also determines the
number of active firms at equilibrium in each quality configuration. If, for
instance, the supply of skilled labour is sufficiently low, there may be no room for
firms selling products of high quality because their costs would be too high to
profitably compete. Therefore, also the market structure is endogenous in that it
may change with the supply of skilled labour. Second, since the actual value of

Since costs are determined at equilibrium, the value of c i differs according to the type of
equilibrium considered (covereduncovered market, onetwo active firms). In order to avoid excessive
notation, in the following we just denote by c i the marginal cost of firm i. From the text it will be clear
to which cases this notation is referred.
5
As in analogous analyses (e.g., Gabszewicz and Thisse, 1979), this form of the payoff functions
ensures that, at given costs and qualities, the equilibrium in prices with two active firms is either at the
interior of the region where the market is covered, or at the interior of the region in which the market is
uncovered, or at the corner, p2 5p 2 .

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

581

costs depends on the wage rate, and then on the equilibrium labour demand, the
uniqueness of equilibrium in the second stage is not a-priori guaranteed.6 Finally,
since firms in the first stage have to choose their qualities from a discrete set, also
the existence of an equilibrium in pure strategies is not necessarily guaranteed. We
find sufficient conditions under which it is possible to characterize an equilibrium
in pure strategies in qualities. The requirements are that, at a candidate equilibrium
with both firms active, the market is covered and w>r. These requirements turns
out to be necessarily fulfilled when a is sufficiently high, s. ]12 and L ,2M (see
Appendix A for derivation).
At a candidate equilibrium with covered market and two active firms, prices
must be mutual best replies in the domain in which the market is covered. This
pair of prices is thus obtained as the solution of the system formed by first order
conditions for simultaneous maximization of Eqs. (3) and (4) plus equilibrium on
the (skilled) labour market. The system can be solved recursively. Once the system
of first order conditions is solved for given costs, expressions for skilled labour
demand are derived for each quality configuration, and wages are obtained from
equality of supply and demand on the labour market. Wages so obtained must then
be plugged into the solution of first order conditions to obtain (candidate)
equilibrium prices for each quality configuration.
The solution of the (sub)system of first order conditions yields prices p 1* and p *2
as follows:
(a 1 1)(u 1 2 u 2 ) 1 2c 1 1 c 2
p *1 5 ]]]]]]]];
3

(5)

(2 2 a )(u 1 2 u 2 ) 1 2c 2 1 c 1
p 2* 5 ]]]]]]]].
3

(6)

Eqs. (5) and (6) refer to a candidate equilibrium where both firms are active and
the market is covered. Yet, depending on qualities supplied and cost differentials,
those expressions may be meaningless, entailing either negative mark-ups for
some firm, or uncovered market. These requirements must then be checked once
expressions for wages are derived.
The wage rate for skilled workers is determined (simultaneously with prices) by
the equality of supply and demand of skilled labour
3(u m 2 ul )L
w*(m,l) 5 (1 1 a )(u m 2 ul ) 1 r 2 ]]]],
M

(7)

For example, given a set of parameter values, firms costs obtained at a candidate equilibrium in
prices with covered market, and those obtained at a candidate equilibrium with uncovered market, may
be such that the two candidate equilibria are actual equilibria. When uniqueness does not hold, the
payoffs in the first stage are not uniquely determined.

582

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

3(u h 2 u m )L
w*(h,m) 5 (4 1 a )(u h 2 u m ) 1 r 2 ]]]],
M

(8)

(1 1 a )(u h 2 ul )
3(u h 2 ul )L
w*(h,l) 5 ]]]]] 1 r 2 ]]]].
2
4M

(9)

Eqs. (5) and (6) refer to mutual best replies on the region of prices where both
firms are active. For this to be an equilibrium, prices must be mutual best replies
on the whole domain. It is proven that the candidate equilibrium characterized in
Eqs. (5) and (6) is the only equilibrium where both firms are active.
Lemma 1. Second stage equilibria with two active firms can arise only at a pair of
prices where the market is covered.
Proof. See Appendix A. h
In several quality regimes, quality and cost differentials are such that both firms
can be active at equilibrium. In these cases, since the market is covered, equality
of supply and demand for skilled labour fully determines the division of the
product market and then the payoffs in the second stage subgame. There are two
cases, however, where two firms cannot be active. First consider the case in which
firms have chosen the quality configuration (h,m) while L ,M. Plugging Eq. (8)
L
into Eq. (5) one checks that p *h (h,m) 22w*(h,m)5 ]
M 21,0. In this case demand
for skilled labour is so high, and supply so low, that firm h cannot be able to cover
its costs. Thus, if a price equilibrium exists in that case, it is not given by Eqs. (5)
and (6); it must be on the boundary of the strategy space for firm h, with the price
for firm h equal to its cost.
Assume now that L .M and that firms have selected (m,l) in the first stage.
Then, since it cannot exceed M, skilled labour demand is always smaller than L,
and the wage for skilled labour must be equal to r, the excess supply of skilled
labour being absorbed in the production of the outside good. In this case, the costs
differential between firms is zero, i.e., c m 5cl . How the corresponding equilibrium
will be characterized can be easily envisaged by taking into account that the
`
low-quality firm loses a cost advantage vis-a-vis
firm m, thus ending up being
driven out from the market.
Lemma 2. (a) Assume that the variants selected by the firms are given by the pair
( h,m) and L ,M. Then, there exists a unique second stage equilibrium, and the
firm supplying quality m is the only active firm. ( b) Assume that the variants
selected by the firms are given by the pair (m,l) and L .M. Then, there exists a
unique second stage equilibrium, and the firm supplying quality m is the only
active firm. (c) Second stage equilibria with one active firm can arise only in the
cases: ( i) ( h,m), L ,M, ii), (m,l), L .M.

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

583

Proof. See Appendix B. h

All the payoffs for the solution of the first stage game where product variants
are selected are obtained from Lemmas 1 and 2. The outcome of the first stage
game is characterized in the following proposition.7
Proposition 1. The pair of qualities (m,l) is the only equilibrium of the first stage
game when 0,L ,M. When M ,L ,2M, the only equilibrium is ( h,m).
Proof. Suppose first L ,M. By Lemma 1 and 2, payoffs at (m,l) are given by
(M 2 L ) 2
L2
*
]] . Using a standard Bertrand
p *m (m,l)5(um 2ul ) ]
M , p l (m,l)5(u m 2u l )
M
argument, no firm has an incentive to deviate in choosing the same quality as its
opponent. Take the firm supplying quality m. By deviating to h it gains p *h (h,l)5
L2
1
*
]
(u h 2ul ) ]
4M , which is lower than p m (m,l) for any s[( 2 ,1). For the firm in l,
deviation in h is never profitable since ph (h,m)50 by Lemma 2. The pair (m,l) is
therefore a Nash equilibrium in qualities. Uniqueness is easily checked by payoffs
inspection.
Consider now the case M ,L ,2M. By Lemma 1 and 2, payoffs for the two
(L 2 M ) 2
firms at (h,m) are given by p *h (h,m)5(u h 2u m ) ]]
and p m* (h,m)5(u h 2u m )
M
2
( 2M 2 L )
]] . Clearly, no firm wants to choose the quality of its opponent. The firm in
M
h does not deviate to l because it would get pl (m,l)50 by Lemma 2. Finally, the
(2M 2 L ) 2
firm in m does not deviate to l because p *l (h,l)5(u h 2ul ) ]]
is lower than p
4M
1
*m (h,m) for any s[( ]2 ,1). The pair (h,m) is therefore a Nash equilibrium in
qualities. Again, by payoffs inspection, it is readily seen that this equilibrium is
unique. h
A number of comments are in order. First, it appears that equilibrium analysis
leads to what intuition would have spontaneously predicted. With scarce skilled
labour force, firms are induced to choose low average quality, and the wage gap is
wide. On the contrary, with abundant skilled labour force, firms choose high
average quality, with a narrower wage gap. Second, less intuitively, strategic
interaction leads firms to cluster either at the bottom ((m,l)) or at the top ((h,m)) of
the quality ladder. This result to holds as long as p h* (h,l), p m* (m,l) and p l* (h,l),
p m* (h,m), inequalities that are always satisfied under the assumption that the
production function for quality has the O-Ring form. Notice that if one of the
previous inequalities is violated, no stable configuration in qualities exists. The
quality ranking arising from the O-Ring production function, plus the assumption

7
Needless to say, since firms are perfectly symmetrical, it is immaterial to determine which firm
selects which quality. Notice also that Proposition 1 does not cover the case L5M. In this case both
(m,l) and (h,m) are simultaneously first stage equilibria in qualities.

584

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

of covered market are sufficient to guarantee the existence of an equilibrium in

pure strategies.8 Finally, it is worth noting the discontinuous behaviour of the
equilibrium wage rate as a function of the skilled labour supply, L. From
inspection of Eqs. (7)(9) one checks that as L increases, the supply of skilled
labour rises compared with demand, thus leading to a reduction in the equilibrium
wage rate until L5M is reached. At this point, demand for skilled labour has an
upward jump because of a regime switching in the selection of product
qualities. The equilibrium wage rate for skilled labour has an upward shift at this
point.9

4. Endogenous skilled labour supply

So far we have considered an exogenous supply of skilled labour. In this section
we give an illustration of the implications for the industry equilibrium when the
supply of skilled labour becomes endogenous. Assume that a continuum of agents
can decide whether to remain unskilled or to invest in human capital specific to a
given industry. Human capital investments are simultaneous with firms choices
concerning product quality. To become skilled workers, individuals need to
sacrifice a share of their working time in education and training. In making their
choice, individuals compare the cost of their education (in terms of lost income
opportunities as unskilled workers) with the prospects of a higher income if
employed as skilled workers. Since agents are atomistic, they take the wage
differential between skilled and unskilled workers as given. When agents differ
with respect to their innate abilities, so that the time-cost of acquiring skills varies
across agents, at a given wage differential, some of them may find it convenient to
undertake the investment in human capital, while it may not be the case for the
others.
To make things more concrete, assume that the population of workers that
contemplate the idea of investing in skills is uniformly distributed, with density N,
]
]
on the interval [x,
] x], 0,x] ,x,`, on which abilities are inversely ranked. Let
d (x) 2 1
]] , d (x)>1, be the fraction of time that must be invested in training by an
d (x)
]
individual endowed with (dis)ability x. Assume, further, that d (x)52x, so that
the fraction of time that must be devoted to training decreases with ability at an
increasing rate. Since it must be that d (x)>1, then x] > ]12 . A generic agent x invests
in his skills as long as the income he gets as a skilled worker (the wage rate net of
time devoted to training), exceeds the wage of unskilled workers, i.e., as long as

If the market is non-covered it may occur that equilibria in pure strategies do not exist. The reason
is that payoffs comparison in the first stage depends in such a case also on the extent to which the
market is covered (the number of consumers that are willing to buy at equilibrium).
9
Better to say, when L5M, the equilibrium wage is no more a function of L, but a correspondence.

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

w*(1,2)
]]] > r,
d (x)

585

(10)

where w*(1,2) is the equilibrium wage rate for skilled workers when the quality
regime (1,2) 5(m,l),(h,l) or (h,m) is prevailing.
Given the form of the distribution for x and its support, the density of d is
]
]
Nd
derived as f(d )5 ]
. This density is defined on the support [d],d ], where ]d ;2x]
]
x 2x
]
]
]] 10
and d ;2x.
The mass of working time supplied by all the individuals that
invest in their skills is thus given by: 11
]
N
w*(1,2)
N(d 2d] )
]]]
]]]
N s1,2 (L) 5 min ]]
2
d
,
.
]
x] 2x]
r
x] 2x]

F S

(11)

The mass of agents who decide to invest in their skills is determined by the value
of the conjectured wage rate, which, in turn, depends upon the conjectured skilled
labour supply L and the conjectured quality configuration.
An equilibrium for the first stage game with endogenous investments in skills
consists of a pair of qualities (1,2)5(m,l), (h,l) or (h,m) such that no firm is
willing to revise its choice, given those of other agents, plus a supply of skilled
labour which is consistent with individual decisions concerning skills acquisitions,
i.e., such that L5N s1,2 (L). At equilibrium, some individuals may have enough
abilities to always undertake education and training; others, with intermediate
levels of abilities, will only invest in the case w5w*(h,m); others, whose
education costs are very high, will never invest in skills. The fixed point of the
correspondence that determines the supply of skilled labour can be analyzed
graphically. In Fig. 1, N s1,2 (L) is plotted as a function of L. A fixed point is reached
s
s
where the schedule describing N 1,2
(L) crosses the 45 degree line. If the N 1,2
(L)
schedule crosses the 45 degree line before L5M, whatever the conjectured pair of
qualities, then the equilibrium skilled labour supply equals 12

s
m,l

N
]]
]x 2x M[(1 1 a )(u m 2 ul ) 2 (d] 2 1)r]
]
; ]]]]]]]]]]]
,
N
3 ]]
]x 2x (u m 2 ul ) 1 Mr
]

(12)

and the (m,l) is the equilibrium quality configuration (case 1.a). Alternatively, if

10
Recall that, given the density function fy ( y), and the transformation z5g( y), the density function of
g 21 (z)
z is given by fz (z)5u ]]
u fy ( g 21 (z)).
z
11
In order to ensure a positive wage differential between skilled and unskilled workers at
equilibrium, in the following we impose N ,2M.
12
(a 1 4 )(u h 2 u m ) 1 r 2
A positive supply of skilled labour is guaranteed as long as x , ]12 [ ]]]]
] .
r
]

586

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

Fig. 1. Equilibrium supply of skilled labour.

the N s1,2 (L) schedule crosses the 45 degree line after L5M, whatever the
conjectures on qualities, then the supply of skilled labour is given by:

N sh,m ; min

N
]]
]x 2x M[(4 1 a )(u h 2 u m ) 2 (d] 2 1)r]
]
]
]]]]]]]]]]]
, N(d 2d] ) ,
N
3 ]]
]x 2x (u h 2 u m ) 1 Mr
]

(13)

and the pair of qualities (h,m) is supplied at equilibrium (case 1.b).

If the wage of the unskilled is high and the marginal utility of quality, a, is low,
then the only fixed point for the supply of skilled labour is below M; at the
opposite, if the remuneration of unskilled labour is low and consumers attach a
great value to product quality, then the only fixed point is above M. Interestingly,
the cases described above are not always mutually exclusive, as shown in Fig. 1.c.

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

587

A region of parameters exists where N sm,l ,M ,N sh,m , so that both L5N sm,l and
L5N sh,m are possible equilibria.
The two equilibria can be ranked according to some welfare indicator. Total
welfare in our framework is obtained as the sum of producer and consumer
surplus. Since wages and profits cancel out with prices (recall that the market is
covered), the difference in welfare in the (h,m) and (m,l) equilibrium is simply
measured by the difference in the aggregate surplus generated by the consumption
of available variants:
uh,m

W(h,m) 2 W(m,l) 5 M

E [(a 2 u )u ]du 1 M E [(a 2 u )u ]du

h

uh,m

um,l

2M

E [(a 2 u )u ]du 2 M E [(a 2 u )u ]du,

m

(14)

um,l

and is unambiguously positive. The availability of higher quality variants of the

good is welfare improving.

5. Discussion
The indeterminacy of the industry equilibrium is generated in our framework by
the interplay between technological and strategic determinants. The stability of a
low-skills, low-quality equilibrium results from the non-convexity associated with
discrete quality choices on the part of firms. As long as firms are bound to choose
among a discrete and finite set of quality levels, the product variants chosen at
equilibrium will change discretely as L changes, leading to discontinuities in the
equilibrium wage schedule and then to possible multiple equilibria. All factors
affecting the outcome of firms strategic interaction are thus likely to affect not
only the amount of skills and the quality level of the goods that are supplied at
equilibrium, but also the degree of their indeterminacy.
Even minor changes in the elements of the industry structure may have
important consequences on the industry performance in terms of skills and quality.
A marginal reduction in the magnitude of firms set-up costs, or in the extent to
which they are sunk, may affect the number of competing firms, thus leading to
possibly large movements in the long-run supply of skills and quality. Policy
intervention at the margin may also affect firms environment in such a way to
deeply alter the outcome of the industry in terms of skill and quality supply.
Imagine, for concreteness, that the government can commit itself to provide a
production (employment) subsidy to the firm selling variant m, conditionally to the
emergence of the configuration (m,l). The presence of the subsidy increases the

588

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

demand for skilled labour on the part of firm m, and then the wage rate for skilled
workers. The mass of agents willing to become skilled increases with the
conjectured wage rate. Even a tiny subsidy may therefore have large effects if it
shifts the industry from the case depicted in Fig. 1.c. to that of Fig. 1.b., where the
only possible equilibrium is with high-skills, high-quality.
We want to stress that the model presented in this paper has the aim of
illustrating, via an example, the possible issues that can be uncovered from the
analysis of the choice of quality on the part of imperfectly competitive firms when
technical and market linkages relate product quality to workers skills. Our model
may prove to be useful as a starting point for further work, but any policy
prescription descending from our analysis is to be judged as premature. Results are
likely to be sensitive to some of the assumptions we make, especially concerning
production technology.13 Our choice of the O-Ring specification is justified on the
ground of some desirable features it presents. The O-Ring technology permits an
unambiguous interpretation of quality, determines a support on which quality is
defined and allows for the characterization of an industry equilibrium in pure
strategies. As long as there is a finite set of workers types, the O-Ring production
function also necessarily implies that the set of technically feasible qualities is
finite, thus leading to the non-convexities associated with the discrete quality
choice on the part of firms, and then to multiple equilibria. Clearly, many equally
reasonable alternative specifications for technology could be envisaged, and results
similar to those presented in this paper would only obtain provided that workers
with different skills are imperfect substitutes in production. Further research
should investigate the implications for the industry equilibrium descending from
different assumptions concerning the form of competition (price vs. quantity), the
specification of the production technology, and the working of the labour market.

Acknowledgements
`
We would like to thank Jacques Dreze,
Marion Jansen, James Markusen,
Jacques Thisse and Xavier Wauthy for helpful comments and discussions. The
usual disclaimer applies. Alessandro Turrini acknowledges the support from a
European Commission Human Capital Mobility fellowship.

13

Also the form of competition, namely quantity instead of price as the competitive tool used by
firms in the second stage may alter our conclusions. When quantities are chosen in the second stage,
and quality affects variable costs but not fixed costs, cases are shown where firms may (Motta, 1993) or
may not (Gal-Or, 1983) supply different qualities in the first stage.

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

589

Appendix A

Proof of Lemma 1
Sufficient conditions for market coverage and w . r with two active firms
Note first that w.r necessarily requires L [(0,2M), because total demand for
skilled labour never exceeds 2M. From Eqs. (7)(9) it is checked that

a .5

(15)

guarantees w.r in each quality configuration.

The expressions for prices at a candidate interior equilibrium as in Eqs. (5) and
(6) are consistent with the assumption of covered market if it is verified, in each
quality configuration, that p 2 .p 2* . After substitution of the expressions for
equilibrium wages as in Eqs. (7)(9) in firms costs, it is found that a sufficient
condition for this requirement to be fulfilled in each quality configuration is
6u h 2 5u m 1 2r
a . ]]]]].
2u m 2 u h

(16)

The candidate equilibrium described by Eqs. (5) and (6) is an equilibrium in the
second stage only if, taking rival prices and wages as given, no firm has an
incentive to deviate in a region where the market is uncovered or where the rival is
not active.
Checking deviations in an uncovered market region
The low-quality firm (firm 2) may have an incentive to raise its price above p 2
as long as a reduction in its market share is compensated by a raise in its mark-up.
This firm would maximize Eq. (4) under the conjectures that the market is
uncovered, p1 5p 1* (as expressed in Eq. (5)) and w(1,2)5w*(1,2) (as expressed in
Eqs. (7)(9)). Denote by p 2d the price resulting from the solution of this problem.
Computations show that, in each quality configuration, p 2d ,p 2* , which implies
p 2d ,p 2 by Eq. (16). Given the piece-wise concave shape of the profit function, this
means that firm 2 profits are monotonically decreasing above p 2 , and deviations to
an uncovered market region cannot be profitable.
Checking for deviations in a one active firm region
Define by p 1 (resp. p 2 ), the lowest price for firm 1 (resp., firm 2) at which firm 2
(resp. firm 1) can be active on the market by setting p2 5p 2* (resp., p1 5p *1 ).
Observe, first that a profitable deviation at some pi ,p i is only possible if p i .p i .

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

590

In the opposite case, any deviation would only reduce the pricecost margin.
Since, by construction, p i ,p i* , and, by condition Eq. (16), p 2* ,p 2 , firm 2 cannot
have an incentive to deviate to a price below p 2 . Firm 1 could have an incentive to
deviate only if p 1 .p 1 . Yet, easy computations show that p 1 .p 1 violates Eq. (16)
in all quality configurations. No deviations are therefore profitable in the region in
which only one firm is active.
Uniqueness of equilibrium with two active firms is insured if all the other
possible equilibrium characterization are excluded. Alternative two firms candidate
equilibria are at the interior of the region where the market is covered, or at the
corner, where p2 5p 2 . Computations show that Eq. (16) is sufficient to guarantee
that neither of these candidate equilibria can be actually an equilibrium in prices.
We refer the reader to Gabszewicz and Turrini (1997) for computations.
Result 1. Under Eq. (16), prices expressed in Eqs. (5) and (6) constitute the only
Nash equilibrium. h

Appendix B

Proof of Lemma 2
(a) In the configuration (h,m), when L ,M, the only candidate equilibria are
those in which the market is uncovered and only one firm is active. The active firm
may either maximize its profit at the interior, setting a monopoly price p M , or at
the corner, fixing the limit price p L , namely, the highest price at which the rival,
though selling at marginal cost, cannot have a positive market share.

Firm h active
It is first checked that firm h cannot be active. Consider firm h adopting a
limit-price strategy. Denote prices at this candidate equilibrium by the superscript
L, and the wage by the superscript Lh . Only the case of uncovered market after
entry of firm m is to be considered. After computations one observes that, given
condition Eq. (16),
(2u m 2 u h )L
L
L
p h 2 2w h (h,m) 5 2r 1 ]]]] 2 a (2u m 2 u h ) , 0,
2M
so that a limit-price strategy is not feasible for firm h. A fortiori, firm h will not be
in the position to act as a monopolist.

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

591

Monopoly price for firm m

Denote prices at this candidate equilibrium by the superscript M, and the
wage by the superscript Mm . For this to be an equilibrium, it must be verified first
that c h .p M
m . If this is not the case, firm h becomes a monopolist by simply setting
L
2r 1 3u m ]
M ,
its price equal to its marginal cost. One checks that c h .p mM a . ]]]
um
condition that is always verified under Eq. (16). Second, it is to check whether
firm h can have
a positive market share at pm 5c m . Computations yield uh,m .
L
2r 1 3u m ]
M . Third, it is to check whether p M is a best reply in the whole
0a , ]]]
m
2u m 2 u h
domain of strategies. This is the case provided that firm m has not an incentive to
increase its price to a region where also firm h is active. The optimal deviation,
p M,d
m , maximizes the payoff described in Eq. (4) in the case of uncovered market,
under the conjecture ph 5c h and w5w Mm (h,m). Computations show that p mM,d ,p mL .
Given the piece-wise shape of the profit function, this means that profits are
monotonically decreasing above p Lm , so that profitableL deviations in a region where
2r 1 3u m ]
M
firm h enters are not possible. Therefore, a . ]]]
2u m 2 u h is a necessary and sufficient
condition for the existence of an equilibrium with monopoly pricing on the part of
firm m.
Limit price for firm m
Denote prices at this candidate equilibrium by the superscript L, and the
wage by the superscript Lm . Firm m fixes a price that sets to zero uh,m under the
assumption that ph 5c h . As a first requirement for this to be an equilibrium, the
L
2r 1 u m ]
M
limit price must cover the costs of firm m. One checks that p mL .c m a . ]]
2u m 2 u h ,
which is always true when Eq. (16) is satisfied. Second, p Lm must be a best reply to
ph 5c h on the whole domain of strategies. Deviations may be either below or
above p mL . Firm m may have an incentive to reduce its price below p Lm to increase
its market share, letting more consumers enter the market. Solving the problem for
firm m, given the conjectures ph 5c h and w5w Lm (h,m), the optimal deviation, p L,d
m
L
2r 1 3u ]

mM
is found. One checks that p mL .p mL,d a . ]]]
2u m 2 u h . It is also possible that firm m
may find it convenient to increase its price above p Lm , where firm h can enter the
market. Again, the optimal deviation in this case is found after maximization of
Eq. (4) in the case of uncovered market, under the conjectures ph 5c h and

2r 1 ( 3u

u2

m )]
2 2]

m
uh M
w5w m (h,m). Yet, it is checked in this case that p m .p m a , ]]]]
,
2u m 2 u h

L,d

L
2r 1 3u ]

mM
which contradicts Eq. (16). Therefore, a , ]]]
2u m 2 u h is a necessary and sufficient
condition for the existence of an equilibrium with limit pricing on the part of firm
m.

Result 1. When the quality configuration is (h,m) and L ,M, only firm m can be

592

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

L
2r 1 3u ]

mM
active. The only equilibrium in prices is [ ph 5c h , pm 5p mM ] if a . ]]]
2u m 2 u h
L
2r 1 3u ]

mM
(monopoly price) or [ ph 5c h , pm 5p mL ] if a , ]]]
2u m 2 u h (limit-price).

(b) When the pair of qualities is (m,l) and L .M, skilled labour demand is
necessarily lower than supply, so that w(m,l)5r and c m 5cl . It is immediate from
inspection of Eq. (6) that condition Eq. (15) in such a case entails a negative
mark-up for firm l. The only equilibrium in this case is limit-pricing on the part of
firm m. At this price, w(m,l)5r, firm m covers its costs and the market is covered,
2r
because p Lm ,p m a .11 ]
u l is the only case consistent with Eq. (16). Firm m has
thus no incentive to reduce its price below p Lm (a monopoly-price equilibrium is
therefore excluded). The only possible deviation is above p mL , where also firm l is
active. This price is the solution to problem Eq. (3) (given pl 52r and w(m,l)5r),
and is above p Lm if and only if a ,2, condition that violates Eq. (15). Therefore
deviations from a limit-price cannot be profitable for m. Uniqueness is guaranteed
because in this case costs are exogenous.
Result 2. When the quality configuration is (m,l) and L .M, only firm m can be
active. The only equilibrium in prices is [ pm 5p mL , pl 5cl ].
(c) Equilibria where the firm l is the only to serve the market are excluded by a
simple argument. In such cases, labour demand is necessarily lower than labour
supply, so that w5r. Since low-quality firms cannot have any cost advantage in
these cases, they cannot have a positive mark-up by fixing a price that excludes
from the market their high-quality rivals.
Consider now the case (h,m). By result (1) and (2), firm h can never be the only
active firm. Take then (m,l) and L ,M. In such a case, when firm m fix its
limit-price, p Lm , all consumers M are willing to buy the good, so that skilled labour
demand is equal to M. Yet, since L ,M, there is excess demand on the skilled
labour market and [ pm 5p mL , pl 5cl ] cannot be a second stage equilibrium. The
same argument applies to the case (h,l), where skilled labour demand equals 2M,
which, by assumption, is always greater than skilled labour supply, L.
Result 3. Equilibria with only one active firm are possible only in the cases (h,m),
L ,M and (m,l), L .M. h

References
Acemoglu, D., 1994. Search in the labour market, incomplete contracts and growth. CEPR Discussion
Paper No. 1026, London.
Courakis, A.S., 1991. Labour skills and human capital in the explanation of trade patterns. Oxford
Economic Papers 43, 443462.

J. Gabszewicz, A. Turrini / Int. J. Ind. Organ. 18 (2000) 575 593

593

Daly, A., Hitchens, D., Wagner, K., 1985. Productivity, machinery and skills in a sample of British and
German manufacturing plants. National Institute Economic Review, February, 0 (111), 4861.
Gabszewicz, J., Thisse, J.-F., 1979. Price competition, quality, and income disparities. Journal of
Economic Theory 20, 340359.
Gabszewicz, J., Turrini, A., 1997. Workers skills, product quality and industry equilibrium. CORE
Discussion Paper No. 9755, August 1997, Louvain-la-Neuve.
Gal-Or, E., 1983. Quality and quantity competition. Bell Journal of Economics 14, 590600.
Kremer, M., 1993. The O-Ring theory of economic development. Quarterly Journal of Economics 108,
551575.
Mason, G., Van Ark, B., Wagner, K., 1996. Workforce skills, product quality and economic
performance. In: Booth, A., Snower, D.J. (Eds.), Acquiring Skills. Cambridge University Press,
Cambridge.
Motta, M., 1993. Endogenous quality choice: Price vs. quantity competition. The Journal of Industrial
Economics 41, 113129.
Mussa, M., Rosen, S., 1978. Monopoly and product quality. Journal of Economic Theory 18, 301317.
Oulton, N., 1996. Workforce skills and export competitiveness. In: Booth, A., Snower, D.J. (Eds.),
Acquiring Skills. Cambridge University Press, Cambridge.
Redding, S., 1996. The low-skills, low-quality trap: strategic complementarities between human capital
and R&D. Economic Journal 108, 458470.
Snower, D.J., 1994. The low-skill, bad-job trap. CEPR Discussion Paper No. 999, London.
Shaked, A., Sutton, J., 1983. Natural oligopolies. Econometrica 51, 14691483.
Steedman, H., Wagner, K., 1987. A second look to productivity, machinery and skills in Britain and
Germany. National Institute Economic Review, November, 0 (122), 8495.
Webster, A., 1993. The skill and higher educational content of UK net exports. Oxford Bulletin of
Economics and Statistics 55 (2), 141160.