Price and Advertising Signals of Product Quality

Citation: Paul Milgrom, John Roberts Price and Advertising Signals of Product Quality.
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Summary

The primary purpose of this paper is to study the role of pricing and advertising for newly introduced experience goods. Experience goods are products with aspects of quality that can’t be verified before using the product. The authors present a signaling model that formalizes Phillip Nelson’s insight. Nelson’s important insight was that the simple fact that a specific brand of an experience good was advertised could be a signal to customers that the brand was of high quality and that a high-quality product is more likely to attract repeat purchases and, therefore, firms of such products will be willing to spend more on advertising to attract initial sales. The authors of this paper confirmed and extended Nelson’s point that advertising may signal quality, but price signaling will also typically occur, and the extent to which each is used depends on the difference in costs across qualities. They also state that all required signaling takes place using price unless the selected price by itself doesn’t achieve the necessary differentiation. In this case and only in this case is advertising used as a signal. Finally, since there are many ways of generating sales, ambiguity remains even after specifying the price and beliefs. If a sale is somehow obtained without changing price or perceived quality, then at price PT and a perceived high quality, the marginal profit for the firm from an extra sale is greater than that for a low quality firm. On the other hand, if the additional sales are generated through extra advertising, the marginal benefit is greater for the low quality producer as long as price doesn’t exceed price PT; if price is the means used to increase sales, then the net marginal benefits from an additional sale is negative. And if cost of production for a firm producing high quality products is greater than the cost for producing low quality products, then in separating equilibrium with signaling, this marginal benefit is always at least as large for the low-quality producer.