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Competitive pricing despite search costs when lower price signals quality

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  • Sander Heinsalu

    (Australian National University)

Abstract

The Diamond paradox demonstrates that when learning prices is costly for consumers, each firm has market power. However, making firms privately informed about their quality and cost restores competitive pricing if quality and cost are negatively correlated. Such correlation arises from, e.g. regulation, differing equipment or skill, or economies of scale. If good quality firms have lower costs, then they can signal quality by cutting prices, in which case bad quality firms must cut prices to retain customers. This price-cutting race to the bottom ends in an equilibrium in which all firms price nearly competitively and cheap talk reveals quality.

Suggested Citation

  • Sander Heinsalu, 2021. "Competitive pricing despite search costs when lower price signals quality," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 71(1), pages 317-339, February.
    • Handle: RePEc:spr:joecth:v:71:y:2021:i:1:d:10.1007_s00199-020-01247-3
    DOI: 10.1007/s00199-020-01247-3
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    References listed on IDEAS

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    Cited by:

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    2. Anton, Ramona & Chenavaz, Régis Y. & Paraschiv, Corina, 2023. "Dynamic pricing, reference price, and price-quality relationship," Journal of Economic Dynamics and Control, Elsevier, vol. 146(C).
    3. Joonbae Lee & Hanna Wang, 2023. "Ranking and search effort in matching," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 75(1), pages 113-136, January.

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    More about this item

    Keywords

    Price signalling; Diamond paradox; Incomplete information; Price war;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D41 - Microeconomics - - Market Structure, Pricing, and Design - - - Perfect Competition

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