Monopolistic Competition when Price and Quality are Imperfectly Observable

Abstract

Consider the symmetric equilibrium of a monopolistically competitive industry in which manufacturers select price and quality to maximize expected profit and consumers maximize utility by conducting costly search among sellers using an optimal sequential search rule. Consumers search among sellers because (i) each consumer idiosyncratically evaluates each seller's quality and (ii) a retailing sector generates variation in the prices consumers pay. Consumers are handicapped in their search because their observations of firms' price and quality levels are noisy. An improvement in price information is represented by an increase in the precision with which consumers observe sellers' prices. Similarly, an improvement in quality information is represented by an increase in precision with which consumers observe sellers' quality levels. An improvement of either type of information may increase or decrease welfare. The perverse case in which improved price information decreases welfare occurs when price competition among firms becomes so intense relative to quality competition that firms select severely suboptimal levels of quality. * A consumer searching among monopolistically competitive sellers may have difficulty accurately observing the price and quality of each seller's product. He must infer from his prior beliefs and noisy observations the true values of the product's price and quality attributes. We show that increasing the precision with which consumers observe an attribute of a product makes the inference problem easier and causes the demand the seller faces with respect to that attribute to become more elastic. The equilibrium level of that attribute changes accordingly, and since the equilibrium levels of price and quality interact, the equilibrium level of the other attribute changes as well. These equilibrium effects can be perverse in two ways. First, if the precision of quality observation is fixed, then improvement in the precision of price observation can reduce welfare. The chain of causation is this: Increasing the precision of price observation causes price to fall. The resulting, smaller price-cost margin induces sellers to reduce quality. De