The Shaked-Sutton model derives from a series of papers written by Avner Shaked and John Sutton. This model is centred in studying vertical differentiation and its role when discriminating the market, in order for firms to absorb as many consumers’ surplus as they can and the consequences this has for the market.
Vertical differentiation between products means discriminating goods as a result of their different qualities. Quality is a characteristic that all consumers want. Given the same price, higher quality products will always be chosen. However due to different income levels that vary from a to b, consumers will have different willingness to pay. This way, individuals with higher incomes will buy goods of higher quality paying a higher price, while lower income individuals purchase lower quality goods at a lower price. Given a higher spread of income between consumers, there will be a higher number of firms in the market each producing a different quality, and thus, making the number of firms in the market subject to the dispersion of incomes.
Firms will have to go through two key decision stages. In the first stage firms will have to choose the quality of their products, taking into consideration that higher quality goods have associated a higher production cost but are also preferred by consumers. Due to this firms are encouraged to produce higher quality goods as it will increase the competitiveness of their product. On the second stage firms will set their prices. Once the quality of the product is determined, firms will want to maintain the greatest differentiation for their product in order to raise their market power.
In markets with a great number of firms, competition between firms will be translated into a lower price for higher quality goods and will end up driving lower quality goods out of the market. A finite number of firms will exist in equilibrium depending on the size of the market and of the cost function associated to the firm. If the market is in equilibrium it will only allow as many firms as different demands of quality are.