Product differentiation under imperfect information: When does offering a lower quality pay? |
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Authors: | Bing Jing |
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Institution: | (1) Stern School of Business, New York University, 44 West 4th Street, KMC 8-79, New York, NY 10012, USA |
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Abstract: | In this paper, we extend the Varian (1980) model to examine endogenous quality differentiation by firms, with a particular
emphasis on the interplay between the firms’ product quality decisions and the ensuing price rivalry. Specifically, we assume
that the price-sensitive (or informed) consumers hold a lower valuation for product quality than the brand-loyal (or uninformed)
consumers. It is shown that the firms will choose differentiated qualities for a broad class of consumer utility functions
and production technologies. We obtain two results. First, the equilibrium quality choices are efficient as they are also
the welfare-maximizing qualities chosen by a social planner. The equilibrium qualities are as if one firm serves only its
loyal consumers and the other serves only the price-sensitive consumers, even though they each serve both types of consumers
(at least for some fraction of time). Second, the firm choosing the lower quality makes greater profits and also prices more
aggressively, in the sense that it maintains a lower maximum price and offers discounts more often. The lower-quality product
is more profitable because it yields higher social surplus when consumed by the price-sensitive consumers.
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Keywords: | Imperfect information Price promotion Product differentiation |
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