Price signaling with word of mouth communication

What is it about?

Firms are often better informed about the quality of the product they provide. In this situation, they might use prices as signal of quality. At the same time, consumers may learn from their peers' past experiences. This paper study how the firm's signaling strategy is affected by word-of-mouth communication among consumers. The main result is that (contrary to the standard signaling literature) low prices signal high quality. In particular, low prices lead to increased product exposure, which amplifies the good (or bad) news generated through word-of-mouth communication. Since high-quality firms are more likely to generate good news about quality, they benefit more from charging low prices.

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Why is it important?

The main contribution of this paper is to allow learning in equilibrium from both prices and other consumers, in a setting in which firms are equally efficient (quality and costs are not correlated). From a technical point of view, the paper provides an insight on how to characterize separating equilibria when the Spence-Mirrlees condition is not sufficient. In particular two cross-derivatives, standard single-crossing and “sensitivity” single-crossing properties, are sufficient for the existence of separating equilibria. Moreover I use the precision criteria proposed by Ganuza and Penalva (2010) to order signals received by second-period consumers, based on their relative precision and impact on the belief function.