Price competition and reputation in markets for experience goods: an experimental study

• Published date: 01 February 2016
• DOI: http://doi.org/10.1111/1756-2171.12120
• Author: Jean‐Robert Tyran,Steffen Huck,Gabriele K. Lünser
• Date: 01 February 2016

RAND Journal of Economics

Vol.47, No. 1, Spring 2016

pp. 99–117

Price competition and reputation in markets

for experience goods: an experimental study

Steffen Huck∗

Gabriele K. L¨

unser∗∗

and

Jean-Robert Tyran∗∗∗

Weexperimentally examine the effects of price competition in markets for experience goods where

sellers can build up reputationsfor quality. Wecompare price competition to monopolistic markets

and markets where prices are exogenously fixed. Although oligopolies benefit consumers regard-

less of whether prices are fixed or endogenously chosen, we find that price competition lowers

efficiency as consumers pay too little attention to reputation for quality. This provides empirical

support to recent models in behavioral industrial organization that assume that consumers may,

with increasing complexity of the marketplace, focus on selected dimensions of products.

1. Introduction

The last decade has seen a flourishing theoretical literature in behavioral industrial organiza-

tion (for a survey, see Huck and Zhou, 2011; for a textbooktreatment, Spiegler, 2011). Although

this literature has received widespread attention among policy makers, there is still only scant

empirical evidence on the interaction between boundedly rational consumer behavior and com-

petition. A notable exception is a recent experimental study by Kalayci and Potters (2011) who

examine duopolies where sellers can increase the complexity of their pricing strategies. In line

with theoretical predictions, they find that sellers make use of complex pricing and successfully

create confusion among consumers, thus, increasing their profits.

Our study adds to this evidence by documenting howconsumers who face two dimensions of

offers, a seller’s reputation for quality and price, start to focus on one of these, price. This mirrors

assumptions made in a number of theoretical behavioral industrial organization (IO) articles,

∗WZB Berlin and UCL; steffen.huck@wzb.eu.

∗∗UCL and ELSE; gabriele.luenser@gmail.com.

∗∗∗University of Vienna and University of Copenhagen; jean-robert.tyran@univie.ac.at.

Huck and L¨

unser acknowledge financial support from the Economic and Social Research Council (UK) via ELSE and

an additional grant on “Trust and competition.” Huck is also grateful for additional funding by the Leverhulme Trust and

the ERC grant “Investors’ expectations: measuring their nature and effect.” Tyran acknowledges financial support from

the Norwegian Research Council under Project no. 212996/F10. An earlier version of this article was circulated under

the title “Pricing and trust.”

C2016, The RAND Corporation. 99

100 / THE RAND JOURNAL OF ECONOMICS

notably Spiegler (2006). Consumers’ focus on price drives down prices to the Bertrand level but

at the same time lowers quality when compared to exogenously fixed prices. As a consequence,

total welfare is reduced.

We implement our investigation in the context of a market for experience goods. Buyers of

an experience good are uncertain about its quality before they buy but learn (or experience) the

good’s quality after having bought and consumed it. Experience goods cover the broad middle

ground between the extremes of goods involvingno quality uncertainty at all (so-called inspection

or search goods) and goods for which quality is not fully revealed even after the consumption

(credence goods). Whenever contracts for the exchange of a good are incomplete and sellers have

leeway to shade its quality about which the consumer finds out only if it is too late, the good in

question is an experience good. Hence, many are.

A key role in markets for such goods is assumed by trust. Buyers may buy an experience

good if they trust sellers to provide high quality and will abstain if they do not. In other words,

trust induces the demand for experience goods. In contrast, lack of trust impedes mutually

advantageous transactions and results in low market efficiency.

Weexperimentally examine the effects of flexible and fixed prices in markets for experience

goods. To the best of our knowledge, ours is the first study to investigate the role of price

competition and reputations in markets for experience goods. We study two types of markets,

monopolies and four-firm oligopolies. In both cases, buyers can observe previous histories of

sellers (their reputations) and the chosen or exogenouslyset price before they make their decisions.

With flexible prices, we observe low prices and high quality in competitive (oligopolistic)

markets and high prices coupled with low quality in noncompetitive (monopolistic) markets. We

then introduce a regulated intermediate price roughly halfway between the observed oligopoly

and monopoly prices. The effect in monopolies is pretty much as standard intuition wouldpredict.

As price falls, volume increases and so does the quality of traded goods. Both effects imply a

rise in efficiency of around 50%. Surprisingly, the same effects occur when we introduce the

regulated intermediate price in oligopolies. In contrast to standard intuition, demand does not fall

in reaction to the price increase and quality rises even further, rendering the regulated oligopoly

the most efficient market by far.

This counterintuitive effect of price regulation can be explained as follows. Under

unregulated Bertrand competition, consumers start to ignore reputations and focus on price

when choosing a seller. Consequently, prices fall to a very low level where buyers’ damage

from buying a “lemon” is getting small, which adds to consumers’ “careless” focus on price.

If, on the other hand, higher prices are exogenously imposed, buyers are forced to pay more

attention to reputations—after all, reputations are now the only attribute that differs between

sellers—and buying from a low-quality firm does hurt them now much more substantially. With

regulated prices, firms lose one of their two “marketing instruments.” The only dimension they

can now compete on is quality. Thus, there are demand- and supply-induced forces that push

up quality. In unregulated oligopolies, almost 20% of all traded goods are lemons (despite an

accurate eBay-style feedback mechanism that allows all buyers to track the entire history of all

sellers). With price regulation, the lemon share falls to just 6%. This increase in quality also

more than offsets the increase in price such that also the trade volume is higher despite the higher

price.1

The causal chain in monopolies has only two simple steps. There, a lower regulated price

increases demand as textbooks would have it. The increase in demand is such that it becomes

more costly for monopolists to lose the trust buyers place in them and, consequently, they supply

higher average quality.

1This complex relation between price, quality, and trust is at the core of an interesting book in the management

literature (Sako, 1992) comparing interfirm relations in Britain (low price, low trust, low quality) and Japan (high price,

high trust, high quality).

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