Pricing High quality High c High p c = 1 or 2 (H type) = 0 (L type) A Low quality firm could signal a high quality by pricing high.
Game theoretical prediction “All requisite signaling takes place through price. When price by itself cannot achieve the necessary differentiation, only in this case is advertising used as a signal.” – Milgrom et al., JPE (1986) Dissipative advertising is more expensive than a low price as a means to deter entry. “When a low quality firm mimics a High quality firm by quoting a high price, it can afford / risk to advertise more.” “In order to differentiate, a high quality firm should price high and advertise low.” – Hao Zhao, Marketing Science (2000)
The experiment looks at the scenario where the market moves from a Monopoly to a Duopoly. The good is an Experience good and the quality perception is ‘relative’. The robustness of the theoretical prediction is tested under different scenarios: A H type incumbent threatened by a L type entrant. A L type incumbent threatened by a H type entrant. Three periods – more realistic? H type firm with a low or high cost (1 or 2).
R ‘n D L H (c = 1) H (c = 2) Period Price
Advertising L H (c = 1) H (c = 2)
H Incumbent L incumbent L entrant H entrant L H
L type - Price As an incumbent it set very high prices ( ) in period 2, mimicking a H type incumbent and forcing the H type entrant to set lower prices. In period 3 it tried to mimic the H type entrant by setting low prices but ended up setting lower prices than the entrant ( ). As an entrant it observed high prices and set a price that seemed to mimic a H type entrant. This price was however lower than the price of the incumbent H type.
L type - Advertising As an incumbent it set high advertising in period 2, mimicking a H type incumbent ( ). In period 3 it reduced its advertising ( ) and this was lower than that of the entrant H type. As an entrant it observed high advertising and set low advertising ( ) that was lower than that of the H type incumbent and also lower than what a H type entrant would set.
H type - Price As an incumbent it set prices that were higher than the L type entrant ( ). As an entrant it observed high prices and tried to differentiate by setting low prices ( ) (mimicked by the L type entrant).
H type – Advertising As an incumbent it differentiated itself by setting high advertising which was higher than that of the L type entrant and was higher than that of a L type incumbent. ( ) As an entrant it observed high advertising and went for high advertising which was higher than that of the L type incumbent and was also higher than that of a L type entrant. ( )
Bottom line A L type incumbent was, to some extent, able to mimic a H type, more so in pricing than in advertising. A L type entrant did a poor job of mimicking a H type incumbent by setting low prices and low advertising. A H type incumbent differentiated itself by setting high prices and high advertising than the L type entrant or a L type incumbent. A H type entrant was able to differentiate itself thru high advertising though its strategy of low price was mimicked by by the L type incumbent.
Avg. profits per period: 3 rd pd. profits L type incumbent - $ 3.40($ 6.10) L type entrant - $ 2.50($ 2.50) H type incumbent - $ 5.81($ 8.33) H type entrant - $ 5.25($ 5.25)
Comparison with theoretical prediction In a monopoly the incumbent L type behaves as predicted, setting high price and advertising. When the market moves to a duopoly the prediction does not hold. In a monopoly the incumbent H type did not behave as predicted, setting high advertising. Even as the market moved to a duopoly the H type was able to differentiate itself by advertising high. As an entrant a H type set a low price but it would be better off if it’d price high.