Prices as Signals of Product Quality

Abstract

This paper is concerned with the provision of quality in markets in which consumers have only imperfect information. The analysis focuses on a market for a product that can be produced at different quality levels. All consumers prefer higher to lower quality, but they may differ in their willingness to pay for quality. Producers can produce any quality they like, but higher qualities are more costly to produce. The information in this market is imperfect in the sense that the exact quality chosen by a firm is known only to the firm itself; some information about the quality of a firm's product will, however, reach its potential customers, even if they do not make any special effort to acquire it. Within the framework suggested here, two conclusions are drawn. First, prices may serve as signals which exactly differentiate the available quality levels. That is, there exists a fulfilledexpectations equilibrium at which each price signals a unique quality level. Second, the pricesignals are not arbitrary. Each price-signal exceeds the marginal cost of producing the quality it signals. Such a mark-up depends on the nature of the product-specific information received by consumers—the poorer the information, the higher the mark-up.