Unobserved objective output quality complicates the analysis of firm productivity and demand because higher-quality products entail higher costs but offer greater consumption benefits. Using a panel of firms with output quality data, we decompose quantity-based productivity into fundamental productivity and the costs of quality, and separate the demand residual into fundamental demand and quality benefits. Fundamental demand accounts for most revenue variation, whereas quality’s revenue-enhancing benefits are largely offset by its costs. During the 2008 global financial crisis, shifts in quality diverged from changes in fundamental productivity and demand, highlighting the role of quality in assessing firm and industry performance.
Jing Li, Shengyu Li, Hongsong Zhang (2025) . Accepted at The RAND Journal of Economics
Unobserved output quality complicates productivity and demand measurement because it both raises costs and increases consumer value. Using firm-level panel data, this paper shows that revenue variation is driven mainly by fundamental demand, and that quality moved differently from productivity and demand during the 2008 financial crisis.