L7: Market Power and Quality Flashcards
two different scenarios for quality
search goods: if consumer searches, they can observe quality
- symmetric information between consumers and firms
- firms may under-provide quality relative to social optimum
experience goods: quality only revealed through consumption
- asymmetric information between consumer and firm
- potentially leads to low quality equilibria
incentives for quality provision under symmetric information - spence
spence distortion under perfect competition
monopolist chooses price and quality
demand as a function of quality: the higher the quality, the more consumers are willing to pay
cost as a function of quality and quantity
quality choice by the firm
whole WTP moves so you shift upwards to a new demand curve
- more higher WTP consumers and less lower WTP consumers
- increasing revenue
private vs. social incentives (spence distortion)
case where WTP to pay for quality increases WTP for the good, but the value of increasing quality is lower for the marginal consumer than for the average consumer
- firms sets price depends on marginal and not average consumer
as long as the WTP for the marginal consumer is lower than the average WTP, then the Spence distortion arises and firms provide lower quality than socially optimal
incentives to under-provide quality relative to social optimum
quality discrimination under symmetric information
customers are heterogenous in WTP for quality
designing menu to induce sorting and maximise profits
if firm wants to price discriminate, they have incentive to decrease the quality of the good they want to sell to low-quality individuals
- losing profit on low-quality group since the product is worse
- but gain in certain consumers and extracting more rent from high-quality group
signalling quality for reputation
high quality products survive while low quality products have to set lower prices or exit
firms may be willing to incur losses at the beginning to develop reputation
- once they have reputation, they can increase prices and recover costs
reputation model, Shapiro 1983
firms choose quality, cost increases with quality, competitive market at all levels of quality
expected quality is reputation and once consumed, reputation is actual quality
dynamic model where firms enter but can’t signal quality so consumers have to try it and learn
first period in the reputation model
firm cannot sell higher than low quality goods
- firms losing money since it’s high quality but you have to sell at low quality cost
loss for firms
- firms with high enough quantity incur loss to build reputation
reputation then allows for firms to recover loss in subsequent periods
no milking condition in the reputation model
idea that firms can lower quality to exploit reputation and make profits
- deviating, decreasing quality, decreasing MC and getting profit by tricking consumers
no milking condition is the fact that you cannot exploit the fact you have reputation to try and make profits
- value of discipline is greater than or equal to the value of deviating
- firms get profits in the model with reputation in each period since they need incentive to stay and maintain quality or else they deviate
binds equilibrium since prices have to be a certain value
free entry condition in the reputation model
in equilibrium, entry cannot be profitable
- net present value of entering cannot be positive sine to enter the market, you charge a price given by low quality
binds equilibrium since prices cannot be too high or else new new entrants enter
equilibrium prices in the reputation model
the higher the quality, the bigger the rents since the more reputation you have
firms get rents despite competitive market - reputation that builds so they need to be compensated or they deviate
advertising to signal quality
quality is unknown for new products
advertising separates high from low quality firms
- high quality firms will invest since they know their high quality will be revealed to consumers
- low quality firms cannot spend as much since they won’t get what they spend back since the product is low quality
money burning
- point is to spend a lot to show that you’re confident and that the good is so good you can do it
- rational consumers rationalise this and learn that the firm has to be high quality or they wouldn’t spend so much on advertising
no advertising in the advertising model - Nelson, 1974
without advertising, all firms try to pretend to be high quality and no one can differentiate
for low quality firms, without advertising, their present value = profits of today + profits of tomorrow
firms want to be believed as high quality since they sell as high quality, consumers learn and then they get profits forever as a low quality firm
- if they don’t show this, they get low profits forever
role of advertising in the advertising model
high quality firms engage in advertising A
if A is large enough, the benefits to a low quality firm to trying to be a high quality firm for a single period at the cost of paying A is not enough as opposed to not spending on advertising and just being low quality
- not profitable to pretend to be high quality for one period since A is too high
to achieve separation, A cannot be too large
- if A is too big, no one would do advertising and no one is high quality
- A needs to be high enough that low quality firms cannot use it but high quality firms can still use it
warranties as a sign of quality
high quality products never break, low quality products break with high probability
if product breaks down, firm replaces it through the warranty
- with low quality, probably against your interest to offer a warrant
- if quality is high, cost of offering a warranty is low
