of Department Agricultural Economics Texas A&M University
AGEC636: Industrial Organization Dr. Yanhong Jin
Lecture Notes on Quality and Information Acquisition
1. Topics and Questions
(1). Does the market supply the efcient level of quality? (2). How does the market communicate its quality?
2. Readings
Tirole, J. (1988). The Theory of Industrial Organization. Cambridge, Massachusetts: The MIT Press. Chapter 2. Akerlof, G.A. (1970). The market for Lemons: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics 84(3):488-500. Dorfman, R. and P.O. Steiner (1954). Optimal Advertising and Optimal Quality. The American Economic Review 44(5):826-836. Jin, G.Z. and P. Leslie (2003). The Effect of Information of Product Quality: Evidence from Restaurant Hygiene Grade Cards. The Quarterly Journal of Economics 118(2):409-451. Nelson, P. (1970). Information and Consumer Behavior. The Journal of Political Economy 77(2):311329. Swan, P.L. (1970). Durability of Consumption Goods. The American Economic Review 60(5):884-894. Varian, H.R. (1980). A model of Sales. The American Economic Review 70(4):651-659. (Presented on 12/01)
3. Types of goods
(1). Search goods: quality can be veried when you purchase the good (clothing) (Nelson 1970). (2). Experience goods: quality can only be revealed and validated after the good is bought and consumed (food quality at restaurant) (Nelson 1970). (3). Credence goods: quality can be rarely learned (toothpaste)(Darby and Karni 1973).
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Department of Agricultural Economics Texas A&M University
AGEC636: Industrial Organization Dr. Yanhong Jin
4. Does monopoly provide the efcient level of quality?
4.1. Monopoly outcome versus socially optimal outcome: Example 1
(1). Denitions: p: product price, s: product quality. p(q, s): inverse demand function. c(q, s): total production cost function. (2). Model set-up Monopoly maximizes his prot: max m (q, s)
q,s
(1)
where m (q, s) = qp(q, s) c(q, s) FOCs: p(q, s) + q p(q, s) q p(q, s) q s = = c(q, s) q c(q, s) s (2a) (2b)
Social planner maximizes the social welfare: max m (q, s) + CS(q, s)
q,s q
(3)
where FOCs:
CS(q, s) =
0
p(x, s)dx qp(q, s)
p(q, s) =
q 0
p(x, s) dx = s
c(q, s) q c(q, s) s
(4a) (4b)
(3). Questions to answer What does the difference between equations (2a) and (4a) tell you? What does the difference between equations (2b) and (4b) tell you? What does it mean if
Rq
0 p(x,s) dx s
q
>
p(q,s) s ?
Is it true that the monopolist undersupplies quality
relative to the social optimal? (examples of underprovision or overprovision of quality). What if quality is a perfect substitute for price reduction?
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Department of Agricultural Economics Texas A&M University
AGEC636: Industrial Organization Dr. Yanhong Jin
4.2. Under-provision of Quality when Consumers are heterogeneous
Consumers are heterogeneous indicating by their type such that the probability distribution function is F (). Assuming individual consumers utility U = S P , she/he will buy the product if and only if s P > 0. That is, all the consumers with > the demand, q = 1 F
q s P S
will buy the product. Normalizing the entire consumers to one, we derive
. Based on the demand function, we can derive the inverse demand function p = F (1 q)1 = p = sF 1 (1 q). s (5)
The prot maximization for monopoly and the social planner are max qp c(q, s) = max qsF 1 (1 q) c(q, s)
q,s q q,s q
for monopoly
(6a) (6b)
max
q,s 0
p(x)dx c(q, s) = max
q,s 0
sF 1 (1 x)dx c(q, s) for social planner
Differentiating equations (6a) and (6b) with respect to s yields c(q, s) s c(q, s) s We know that
q 0
= qF 1 (1 q)
q
(7a) (7b)
=
0
F 1 (1 x)dx
F 1 (1 x)dx
q 0
F 1 (1 q)dx = qF 1 (1 q) given q 0. Thus, we have F 1 (1 x)dx F 1 (1 q), q (8)
q 0
where the term on the left-side hand is the average valuation for quality among all consumers who bought the product and the term on the right-side hand is the marginal valuation of the marginal consumer. Therefore, monopolist will under provide quality.
4.3. Applications
The Swan invariance theorem (Swan 1970) Dene: s: durability of one unit product, q = qs: total durability if buying q units, p(qs) = p(q, s)/s: price per unit of durability. Monopoly maximizes his prot: max m (q, s) is equivalent to max m (, s) (why?) q
q,s q ,s
(9)
where m (q, s) = qp(q, s) qc(s) and m (, s) = q p() q q
c(s) s
.
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Department of Agricultural Economics Texas A&M University Question: why is max m (q, s) equivalent to max m (, s)? q
q,s q ,s
AGEC636: Industrial Organization Dr. Yanhong Jin
( q, s) = qp(q, s) c(q, s) = qp(q, s) c(s)q constant return to scale q q p()s c(s) q = s s c(s) = q p() q s FOC with respect to s: dc(s)/s =0 ds Social planner maximizes the social welfare: max SW (q, s) is equivalent to max SW (, s) (why?) q
q,s q ,s q q
(10)
(11) (12)
where SW (q, s) =
0
(p(x, s)dx qc(s)) ds and SW (, s) = q
0
(p()d q c(s)) . x x
FOC with respect to s dc(s)/s =0 ds (13)
Claim: If consumers care only about the total service and if the the production function exhibits constant returns to scale in output, the choice of durability is independent of the market structure (Swan 1970). The Dorfman-Steiner Condition (Dorfman and Steiner 1954) Denitions: a: the advertising level; p: the product price; q quantity demanded; The cost function is assumed to be additive in output and advertising, and the demand function is given by q = D(p, a). The monoplists prot maximization is give blow: max pD(p, a) C(D(p, a)) a,
p,a
(14)
and FOCs with respect to the product price and the advertising level are D(p, a) + p D(p, a) dc D(p, a) = 0, p dq q D(p, a) dc D(p, a) p 1 = 0. a dq a 4 (15a) (15b)
Department of Agricultural Economics Texas A&M University Let
p
AGEC636: Industrial Organization Dr. Yanhong Jin denote the elasticities of demand with respect to price and advertisa pq
=
D(p,a) p p q
and
a
=
D(p,a) a a q
ing, respectively. Re-arrange equations (15a) and (15b) yields the Dorfman-Steiner condition:
=
s q
.
Claim: The monopolists optimal advertising/sales ratio is equal to the ratio of the elasticities of demand with respect to advertising and to price.
5. How to get the quality right?
Because of asymmetric information, there are two types of problems we need to consider: moral hazard and adverse selection: (1). The Moral hazard problem exists on the producer side if quality is not fully observable to consumers (experience goods), or if the potential purchase is one-shot (Think about various examples, including poor quality in the tourist areas). on the consumer side since consumers have no incentive to take care of the good if he is to be fully reimbursed in the case of a breakdown. (2). The adverse selection problem exists if quality is unveriable and nothing else to correct it. (3). The Lemon problem Typically sellers know more about the quality of their products than consumers do. This asymmetry of information may prevent rms with high quality from products proting from it. Firms also have less incentives to invest in improving the product quality because it is hard for consumers to verify which products have high quality. Therefore, sellers put their goods on the market only if the goods are of low quality. The classic reference is (Akerlof 1970). There are several ways to get the quality right, including (1). Informing consumers (2). Warranties, return policies (ex post mechanisms) (3). Demonstrations (ex ante mechanisms) (4). Design multidimensional contracts that specify several attributes in additional to the product price. Sellers use the mix of attributes to signal the unknown characteristics of the product, and consumers can use the variation in the mix of theses attributes to obtain a relatively satisfactory selection of goods and sellers as well. (5). Reputation and signaling
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Department of Agricultural Economics Texas A&M University
AGEC636: Industrial Organization Dr. Yanhong Jin
5.1. Informing consumers
Two types of consumers who are differentiated by their valuation of the product quality (): The informed consumers: A fraction of consumers are perfectly informed about the product quality before buying. (How? They can perform technical tests, read Consumer reports, develop skills that aid them in judging quality, or repeated purchases, etc.) They are willing to pay if quality is high and zero otherwise. The informed consumers buy if s = 1 and p < (16)
dont buy otherwise The uninformed consumers: The remaining (1 ) consumers observe the product quality only after they purchase. The monopolist rm chooses the product price p and the product quality s (s = 1 for the high quality and s = 0 for the low quality) at the cost ci to maximize his prot: p c 1 = (1 )(p c ) 0
if s = 1 if s = 0
.
(17)
The monopolist rm will provide high quality if
p c1 > (1 )(p c0 ) p > Questions to think about:
c1 (1 )c0
(18)
Why do uninformed consumers believe that a high price signals a higher quality? What if there is an increase in ? Jin and Leslie (2003) discuss how increasing information about product quality available to consumers may affect how rms choose the quality of their product.
5.2. Warranties, return policies and other marketing strategies serving as a quality signal
(1). Warranties promise to x or replace a product if it fails to fulll its performance claims within a given period (Lutz 1989; Menezes and Currim 1992). (2). Return policies like money-back guarantee serves as a signal for product quality (Courville and Hausman 1979; William and Kirmani 1993; Matthews and Persico 2005). (3). Building a strong brand to signal quality (Chu and Chu 1994; Aaker 1994). (4). Think about other marketing strategies...
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Department of Agricultural Economics Texas A&M University
AGEC636: Industrial Organization Dr. Yanhong Jin
5.3. Signaling and Reputation in a repeated purchase environment
(1). When quality is xed Assumptions: N unit mass consumers and their utility function is U = s p. Monopoly chooses quality s in he rst period and commit to deliver the same quality in the second period. The marginal production cost of the product with quality s = 1 and s = 0 are c 1 and c0 such that c1 c0 . Consumers buy the product in period 2 if and only if s = 1 in the rst period and p 1 . is the discount rate. Prots 1 = (p1 c1 ) + ( c1 ) if a monopoly chooses the high quality s = 1 in the rst period, (19) = = (p c ) + 0 if a monopoly chooses the low quality s = 0 in the rst period, 0 1 0 1 > 0 ( c1 ) > c1 c0 , (20)
where monopoly will charge the product price at in the second period. Therefore, we
which implies that there is no price signal given the belief that consumers will buy in the second period if s = 1 since the condition to offer s = 1 does not depend on the price. Thus, the price is not informative. Question: What if T periods rather than a two-period model? (2). When quality varies over time The discussion below is the simple version of Klein and Lefer (1981) and Shapiro (1983). Assumptions: The monopolist starts with a price p1 and keeps on charging the same price over time. However, the monopolist chooses the product quality st...