Price competition with uncertain quality and cost

TL;DR

This paper analyzes how consumer uncertainty about firm quality and costs influences optimal pricing strategies, revealing that the relationship between quality, cost, and price depends on information structure and cost-quality correlation.

Contribution

It provides a comprehensive theoretical framework showing how quality and cost correlations affect pricing under different informational settings.

Findings

Optimal pricing depends on consumer heterogeneity and cost-quality correlation.

When higher quality firms have lower costs, quality is sold cheaper under private information.

Price tends to increase with quality when higher quality is associated with higher costs.

Abstract

Consumers in many markets are uncertain about firms' qualities and costs, so buy based on both the price and the quality inferred from it. Optimal pricing depends on consumer heterogeneity only when firms with higher quality have higher costs, regardless of whether costs and qualities are private or public. If better quality firms have lower costs, then good quality is sold cheaper than bad under private costs and qualities, but not under public. However, if higher quality is costlier, then price weakly increases in quality under both informational environments.