Competitive pricing despite search costs if lower price signals quality

TL;DR

This paper demonstrates that in markets with search costs and quality-cost linkages, firms tend to price competitively, allowing consumers to infer quality from prices, leading to a separating equilibrium with distinct pricing strategies.

Contribution

It introduces a model showing how quality and cost differences, combined with search costs, influence firms' pricing strategies and market equilibrium outcomes.

Findings

High-quality firms signal quality by lowering prices.

Low-quality firms also cut prices to compete, leading to a price race.

Market reaches a separating equilibrium with distinct pricing.

Abstract

I show that firms price almost competitively and consumers can infer product quality from prices in markets where firms differ in quality and production cost, and learning prices is costly. Bankruptcy risk or regulation links higher quality to lower cost. If high-quality firms have lower cost, then they can signal quality by cutting prices. Then the low-quality firms must cut prices to retain customers. This price-cutting race to the bottom ends in a separating equilibrium in which the low-quality firms charge their competitive price and the high-quality firms charge slightly less.