Learning quality through prices and word‐of‐mouth communication

Abstract

AbstractThis paper studies the effect of word‐of‐mouth communication on the optimal pricing strategy for new experience goods. I consider a dynamic monopoly model with asymmetric information about product quality, in which consumers learn in equilibrium from both prices and other consumers. The main result is that word‐of‐mouth communication is essential for the existence of separating equilibria, wherein the high‐quality monopolist signals high quality through a low introductory price (lower than the monopoly price), and the low‐quality one charges the monopoly price. The intuition is simple: low prices are costly, and will only be used by firms confident enough that increased experimentation (and therefore communication among consumers) will yield good news about quality and increased future profits. Additional results are the following: for the high‐quality seller, the expected price (quantity) is increasing (decreasing) over time; whereas for the low‐quality one, the opposite is true. Moreover, signaling becomes more difficult when consumers pay less attention to their peers' reports and more attention to past prices. Finally, word‐of‐mouth communication improves consumer welfare.