Imperfect competition and quality signalling

• Author: Andrew F. Daughety,Jennifer F. Reinganum
• DOI: http://doi.org/10.1111/j.1756-2171.2008.00008.x
• Date: 01 March 2008
• Published date: 01 March 2008

RAND Journal of Economics

Vol.39, No. 1, Spring 2008

pp. 163–183

Imperfect competition and quality signalling

Andrew F. Daughety∗

and

Jennifer F. Reinganum∗

We examine the interplay of imperfect competition and incomplete information in the context

of price competition among firms producing horizontally and vertically differentiated substitute

products. Incomplete information about vertical quality (consumer satisfaction) signalled via

price softens price competition. Low-quality firms always prefer the incomplete information

game to the full-information analog. Moreover, for “high-value” markets with a sufficiently high

proportionof high-quality firms, these firms also prefer incomplete information to full information.

We find that an increase in the loss to consumers associated with the low-quality product may

perversely benefit low-quality firms; we consider applications to tort reform and professional

licensing.

1. Introduction

In this article, we examine the interplay of imperfect competition and incomplete information

in the context of a multifirm industry producing horizontally differentiated substitute products with

an associated vertical quality measure, such as consumer satisfaction with a firm’s product. We

find that incomplete information about quality that is signalled via price softens price competition

by firms. Further, weshow that low-quality firms alwaysprefer playing the incomplete information

game to the full-information analog: their prices are higher and so are their profits. Moreover,for

“high-value” markets (suitably defined), if the proportion of high-quality firms is high enough,

high-quality firms also prefer incomplete information to full information. This is in contrast to

the results for a monopolist, who would prefer full information so as to avoid the price distortion

associated with signalling.

Other unexpected results of the interplay between imperfect competition and incomplete

information also emerge; these results reflect both a firm’s best-response behavior vis-`

a-vis its

rivalsand its incentive compatibility conditions vis- `

a-vis its own alter ego.For high-value markets,

equilibrium prices, quantities, and profits for both types of firms are increasing in the proportion

of high-quality firms; this parameter does not affect equilibrium play in the monopoly signalling

∗VanderbiltUniversity; andrew.f.daughety@vanderbilt.edu, jennifer.f.reinganum@vanderbilt.edu.

This research was supported by NSF grant SES-0239908. We thank Kyle Bagwell, Patrick Greenlee, Michael Riordan,

Editor James Hosek, and two referees, as well as participants in seminars at Cambridge University, Columbia University,

Emory University, the London School of Economics, the University of British Columbia 20th Summer Conference on

Industrial Organization (2006), UniversityCollege London, the U.S. Department of Justice, and the University of Southern

California for helpful comments and suggestions on an earlier draft.

Copyright C

2008, RAND. 163

164 / THE RAND JOURNAL OF ECONOMICS

model or in the full-information model. In equilibrium, low-quality firms produce greater output

than do high-quality firms, a reversal of the result that obtains under full-information imperfect

competition. Finally, an increase in the loss borne by consumers due to the low-quality product can

(for portions of the parameter space) perversely increase the low-quality firm’s price, quantity,and

profits; this effect also does not arise in the monopoly signalling model or in the full-information

model. This last result suggests that recent proposals for tort reform may actually increase the

likelihood of harm and lawsuits and that licensing of professional services can result in increased

competitiveness and lower prices.

Plan of the paper. In Section 2, we provide a brief review of the literature. Section 3

provides the model and results. Section 4 discusses some implications and applications of the

model. Section 5 provides a brief summary and conclusions. Supplementary material, including

complex formulas and selected proofs, is contained in the Appendix.1

2. Related literature

There are several strands of literature that are related to this work. One body of related

work involves a monopolist using price to signal product quality. Bagwell and Riordan (1991)

examine a two-type model in which a high-quality product is more costly to produce than is a

low-quality product (we adopt this formulation below, but with multiple firms). In equilibrium,

the low-quality firm chooses its full-information price, whereas the high-quality firm distorts its

price upward relative to the full-information price for high quality.2Daughety and Reinganum

(1995) provide a model with a continuum of types in which quality is viewed as product safety.

When a product fails and harms a consumer, the liability system determines how the associated

losses are allocated across the parties. In equilibrium, higher prices signal safer products when the

consumer bears a sufficiently high share of the loss, whereas lower prices signal safer products

when the firm bears a sufficiently high share of the loss. Daughety and Reinganum (2005)

consider a model in which quality is a safety attribute and the firm may engage in confidential

settlement of lawsuits. Following first-period production, the monopolist learns its product’ssafety

through harmed consumers who seek compensation. The firm settles lawsuits confidentially,

which (potentially) reduces the viability of suits and prevents future consumers from observing

directly the product’s safety. Although confidentiality lowers the firm’sexpected liability costs, it

also depresses demand for its product. Daughety and Reinganum (2005) characterize when this

tradeoff induces the firm to prefer confidentiality versus a regime of openness (in which suits

cannot be settled confidentially, and thus future consumers observe directlythe product’s safety).

There is a strand of the literature which considers price and advertising as joint signals of

product quality. For example, Milgrom and Roberts (1986) provide a two-type monopoly model

in which the cost of high quality may be higher or lower than that of low quality, and repeat

sales are an important attribute of the model. They identify various conditions under which high

quality may be signalled with a high price alone, a low price alone, or a combination of price

and advertising expenditure.3Hertzendorf and Overgaard (2001b) and Fluet and Garella (2002)

examine very similar duopoly models in which firms use price and advertising expenditure to

signal their qualities. Whereas consumers do not know either firm’s quality, both firms know

both firms’ qualities.4Moreover, consumers do not have a preference between the two goods,

1Proofs of Propositions 1, 3, and 4 are provided. Proofs of Propositions 2, 5, and 6 are straightforwardbut tedious,

and are omitted (example calculations are provided for Proposition 6).

2Bagwell (1992) conducts a related analysis of a monopolist producing a product “line.”

3Hertzendorf (1993) argues that, if advertising is stochastically observed, price and advertising expenditure will

neverbe used in combination. Linnemer (1998) considers a fir m whichuses price and adver tising to signal to twodifferent

audiences: it signals its product quality to consumers and its marginal cost to a potential entrant.

4See also Hertzendorf and Overgaard (2001a); Harrington (1987), Bagwell and Ramey (1991), and Orzach and

Tauman (1996) consider limit pricing models in which twoor more incumbent fir ms with common private information

about production costs attempt to deter entry using price as a signal of cost.

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RAND 2008.