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Signaling Quality: Dynamic Price-Advertising Model

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  • G. E. Fruchter

    (Bar-Ilan University)

Abstract

This paper extends the existing quality-signaling literature by investigating the roles of price and advertising levels as quality indicators in a dynamic framework. Considering perceived quality as a form of goodwill, we modify the well-known Nerlove-Arrow dynamic model to include price effects. In our model, price is used both as a monetary constraint and as a signal of quality, while advertising spending is used only as a signaling device, and thus purely as a dissipative expense. Utilizing optimal control, we determine optimal decision rules for a firm regarding both price and advertising over time as functions of perceived quality. The results indicate that, when prices act as monetary constraints and are reduced to increase demand, the firm should use the signaling role of advertising by increasing spending to accelerate perceived quality increases. In cases when the value of the perceived quality goes up together with the increase in the perceived quality by more than the demand, in percentage terms, the firm should increase the price (use its signaling role). At steady-state, we find that the level of optimal profit margin relative to price decreases with the elasticity of demand with respect to the brand price. However, higher elasticity of demand with respect to the firm’s perceived quality and/or a higher impact of price (advertising) lead/leads to a higher optimal profit margin (advertising spending) relative to price (revenue).

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  • G. E. Fruchter, 2009. "Signaling Quality: Dynamic Price-Advertising Model," Journal of Optimization Theory and Applications, Springer, vol. 143(3), pages 479-496, December.
    • Handle: RePEc:spr:joptap:v:143:y:2009:i:3:d:10.1007_s10957-009-9575-7
    DOI: 10.1007/s10957-009-9575-7
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    5. Chenavaz, Régis Y. & Feichtinger, Gustav & Hartl, Richard F. & Kort, Peter M., 2020. "Modeling the impact of product quality on dynamic pricing and advertising policies," European Journal of Operational Research, Elsevier, vol. 284(3), pages 990-1001.
    6. Caulkins, Jonathan P. & Feichtinger, Gustav & Grass, Dieter & Hartl, Richard F. & Kort, Peter M. & Seidl, Andrea, 2017. "Interaction of pricing, advertising and experience quality: A dynamic analysis," European Journal of Operational Research, Elsevier, vol. 256(3), pages 877-885.
    7. 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).
    8. Jiang, Guoyin & Tadikamalla, Pandu R. & Shang, Jennifer & Zhao, Ling, 2016. "Impacts of knowledge on online brand success: an agent-based model for online market share enhancement," European Journal of Operational Research, Elsevier, vol. 248(3), pages 1093-1103.
    9. Fouad El Ouardighi & Gustav Feichtinger & Dieter Grass & Richard F. Hartl & Peter M. Kort, 2016. "Advertising and Quality-Dependent Word-of-Mouth in a Contagion Sales Model," Journal of Optimization Theory and Applications, Springer, vol. 170(1), pages 323-342, July.
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