Imperfect information and quality signaling

Abstract

This thesis consists of three essays on how a firm can use price and/or advertising to signal its unobservable quality.<br>In the first essay, we focus on competition between an incumbent and an entrant when only the entrant's quality is unknown to (some) consumers. The incumbent may or may not know the entrant's quality. The model reveals an additional separating equilibrium in which the incumbent chooses separating prices while the entrant pools. The incumbent's high price signals the entrant's low quality and the incumbent's low price signals the entrant's high quality. Interestingly, entry is facilitated. <br>In the second essay, we re-examine the issue from the first essay in a good market in which products are horizontally differentiated. The model reveals a separating equilibrium where a high price by the entrant can signal its high quality when the proportion of informed consumers is at some intermediate values. The case in which the incumbent is informed of the entrant's type leads to two additional equilibria. When the proportion of informed consumers is large enough, firms play their price strategies as if there were complete information. The entrant's high price in combination with the incumbent's low price signals the entrant's high quality. When the proportion of informed consumers is at some intermediate values, the incumbent's high price signals low quality of the entrant, while its low price signals high quality of the entrant. Further, all these three equilibria are the only equilibra of that type. Interestingly, we find entry may be facilitated with incomplete information.<br>The last essay explores how firms can use price and advertising jointly as a signal of their unobservable choice of quality. Up to now, only price has been used as a signal and advertising has not been considered. Recent attempts have been made to examine the role of price and advertising as a joint signal of firms' unobservable choice of quality. In particular, In and Wright (2009) (hereafter, IW) have developed a general framework for analyzing multidimensional signals of unobservable choices. Following the idea in IW, we develop a model in which a firm can use both price and advertising as a signal of its unobservable choice of quality. We start with the monopoly setting, and support an equilibrium in which the monopolist chooses high quality but a higher level of advertising compared to the full information benchmark in both settings. We then extend our model to the case with competition of two imperfectly competitive firms, and characterize a symmetric equilibrium in which both firms choose high quality, set a lower price and a higher level of advertising. In a numerical example, we find an equilibrium in which the monopoly or the duopoly firm chooses high quality. The equilibrium results show that as competition gets more intense from the monopoly, initially prices decrease and the level of advertising increases.<br>