Prices as signals of quality

• Main Author: Farrell, Joseph von Rosthorn
• Published: University of Oxford 1981
• Subjects: 330; Pricing : Quality of products
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.255575

I consider the workings, under free entry, of some plausible mechanisms enforcing product quality when it is not readily observed by buyers, but is chosen by sellers: there is a moral hazard problem to be overcome. In equilibrium, uninformed buyers can often take price as indicating quality. This is however not the sarne as Spence's signalling notion, since quality is chosen by sellers. It is fruitful to consider price as a commitment, which changes the quality-incentives in a common-knowledge way. In the introduction, I note briefly much of the relevant literature, including my M. Phil, thesis. In Chapter 1, on Repeat-Sales, I consider a continuous model of that incentive to quality. With strong simplifying assumptions, I am able to solve for 'competitive' equilibrium, which involves a bunding of buyers at the minimum quality level, price premia for higher qualities, and consequent inefficiencies. The second chapter is the theory of cheating. It is possible, but costly, for buyers to be 'vigilant'; but equilibrium cannot involve their all being vigilant. There are various externalities between buyers. Different prices can exist in equilibrium, with different honesty levels. I identify a key feature of the cost function, which (together with buyers' tastes, etc.) determines equilibrium. In Chapter 3, I consider introductory offers and their role in entry and quality-signalling, when buyers are very rational. When buyers are identical, a single entrant will never use introductory offers. If there are many entrants, a low first-period price will be observed, but it conveys no information. Only some quality levels can (credibly) be promised by an entrant, and the result is that an incumbent can make positive profits but prevent entry.