Public Report, Price, and Quality

• Date: 01 June 2014
• Published date: 01 June 2014
• Author: Ching‐to Albert Ma,Henry Y. Mak
• DOI: http://doi.org/10.1111/jems.12050

Public Report, Price, and Quality

CHING-TO ALBERT MA

Department of Economics

Boston University

270 Bay State Road, Boston, MA 02215

ma@bu.edu

HENRY Y. MAK

Department of Economics

Indiana University-Purdue University Indianapolis

425 University Boulevard, Indianapolis, IN 46202

makh@iupui.edu

A monopolist produces a good with two qualities. All consumers have the same valuation of the

first quality, but their valuations of the second vary, and are their private information. A public

agency can verify qualities, and make credible reports to consumers. In Full Quality Report, the

public agency reports both qualities. In Average Quality Report, it reports a weighted average

of qualities. The equilibrium prices and qualities in Full Quality Report can be implemented

by Average Quality Report. Equilibrium prices and qualities in Average Quality Report give

higher consumer surplus than Full Quality Report. Bertrand competition under Average Quality

Report yields first-best prices and qualities.

1. Introduction

Empowering consumers with product information is often regardedas a plausible way to

solve the problems of experience goods, whose qualities are unknown before purchase.

This information often comes in the form of ratings and rankings. For example, US

News and World Report (USNWR ) ranks colleges and graduate schools. The National

Commission on Quality Assurance (NCQA), which works with the Centers for Medicare

& Medicaid Services, compares health care providers, insurance plans, and nursing

homes across the United States. Consumer Reports rates consumer products and services

by indexes. Such information generally can be regarded as a form of quality index.

What is the impact of quality index on market outcomes? It is clear that firms react

to quality indexes. For example, when the British hospital rating system assigned zero

weight to women and children services, clinicians reported that hospitals reduced those

qualities (Mannion et al., 2005). Stake (2006) discusses how the USNWR Law School

Ranking has affected resource allocation in law schools. Obviously, consumers should

be mindful about firms’ reactions. Regulatory agencies and watchdog organizations

We thank Sambuddha Ghosh, Jacob Glazer, Steve Matthews, and seminar participants at Boston University,

Carlos III Universidad de Madrid, City University of Hong Kong, Duke University, INSEE, University of

Munich, University of Naples Fedrico II, the US Department of Justice, the Ninth Annual International

Industrial Organization Conference in Boston, and the 10th Annual Columbia-Duke-Northwestern IO Theory

Conference for their comments. Wealso thank a Coeditor and two referees for their advice. Part of this research

was done while the first author was visiting Carlos III Universidad de Madrid, and TuftsUniversity and while

the second author was with the Max Weber Programme at the European University Institute; their financial

support and hospitality are acknowledged.

C2014 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume23, Number 2, Summer 2014, 443–464

444 Journal of Economics & Management Strategy

should educate consumers on how quality indexes are to be used. A deeper question,

however, is how quality indexes should be constructed. In this paper, we study optimal

quality indexes.

We study quality index as a mechanism design problem. In our model, a public

agency announces how quality indexes are to be constructed. A monopolist produces

goods with multiple quality attributes, then chooses prices to offer them to consumers.

The qualities of each offered good are observed by the public agency, and the indexes

will be constructed according to the decided rules. The quality indexes are then disclosed

to consumers. Finally,consumers decide whether to purchase at the set prices. We derive

the optimal quality indexes for the maximization of consumer welfare.

Our main result is that the optimal quality indexes generate more consumer and

social surpluses than when all quality information is disclosed to consumers. If the public

agency releases all quality information, the firm freely chooses its second-degree price-

quality discrimination strategies. If the public agency discloses only quality indexes, but

not all information, the firm must choose its qualities optimally to achieve any index.

Consumers therefore infer that only such qualities are equilibrium choices. This actually

restrains the firm’s price-quality discrimination strategies. Therefore, carefully chosen

indexes can benefit consumers.

We call the above the Average Quality Report regime, where indexes are weighted

averages of a firm’s product qualities. When the public agency discloses all quality

information, we call that the Full Quality Report regime. Qualities and prices under

Average Quality Report generate higher consumer welfare than Full Quality Report.

The result remains true if the public agency aims to maximize a weighted sum of

consumer surplus and profits (with a lower weight on profits), or if the public agency

bans second-degree price-quality discrimination.

The two regimes generate the same consumer surplus when the market is compet-

itive. In this case, the public agency releasing all information will implement the first

best, so Full Quality Report is optimal. The interesting observation is that the public

agency can implement the first best by Average Quality Report. The public agency can

construct the indexes to implement first-best quality strategic responses.

A provocative policy implication of our model is the regulation of quality certifi-

cation. Average Quality Report imposes a constraint on the monopolist. Therefore, the

monopolist would like to hire a third party to verify its product qualities to remove the

constraint. Consumers are better off if the government disallows the monopolist to hire

its own certification agent. The government then intervenes by observing the qualities

and reporting optimal quality indexes. Our model provides a justification for why many

reports are indexes and compiled by nonprofit and public organizations.

Many papers study how quality information influences the interaction between

firms and consumers. In Matthews and Postlewaite (1985) and Schlee (1996), quality is

one dimensional, exogenously given, but may be unknown to either the firm, consumers,

or both. These papers compare full quality disclosure and nondisclosure. They show

that quality information may harm consumers due to the seller responding with higher

prices. By contrast, in this paper, the firm chooses both prices and multiple qualities.

Here, nondisclosure will lead to the collapse of the market. Full disclosure allows the

firm to perform second-degree price-quality discrimination. Partial disclosure in our

model benefits consumers by restraining the firm’s price and quality strategies.

Several recent papers analyze disclosure of multiple quality attributes. In Sun

(2011) and Hotz and Xiao (2013), firms produce a good with both horizontal and vertical

attributes. These papers show that neither a monopolist nor duopolists may disclose an