When Does Variety Increase with Quality?

In this paper we provide a novel explanation of the relationship between product quality and variety. We develop a simple theoretical model with nearly rational consumers, who randomize among all alternatives that yield the same utility for them but could make a mistake of choosing a slightly worse alternative. We show that it is optimal for a firm to offer more varieties of its higher quality, more profitable, products, in order to price discriminate more effectively. When the market is thin at the very top quality level, the number of varieties first increases and then decreases, which results in the overall hump-shaped relationship between the number of varieties and quality. We find empirical support for our qualitative predictions in the Australian car market.