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Reexamining the Schmalensee effect

Listed author(s):
  • Kim, Jeong-Yoo
  • Berg, Nathan

The authors reexamine the Schmalensee effect from a dynamic perspective. Schmalsensee's argument suggesting that high quality can be signaled by high prices is based on the assumption that higher quality necessarily incurs higher production cost. In this paper, the authors argue that firms producing high-quality products have a stronger incentive to lower the marginal cost of production cost because they can then sell larger quantities than low-quality firms can. If this dynamic effect is large enough, then the Schmalensee effect degenerates and, thus, low prices signal high quality. This result is different from the Nelson effect relying on the assumption that only the high-quality product can generate repeat purchase, because the result is valid even if low-quality products can also be purchased repeatedly. The authors characterize a separating equilibrium in which a high-quality monopolist invests more to reduce cost and, as a result, charges a lower price. Separation is possible due to a difference in quantities sold in the second period across qualities.

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File URL: http://dx.doi.org/10.5018/economics-ejournal.ja.2017-5
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File URL: https://www.econstor.eu/bitstream/10419/156480/1/883821699.pdf
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Article provided by Kiel Institute for the World Economy (IfW) in its journal Economics: The Open-Access, Open-Assessment E-Journal.

Volume (Year): 11 (2017)
Issue (Month): ()
Pages: 1-12

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Handle: RePEc:zbw:ifweej:20175
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  1. Daughety, Andrew F & Reinganum, Jennifer F, 1995. "Product Safety: Liability, R&D, and Signaling," American Economic Review, American Economic Association, vol. 85(5), pages 1187-1206, December.
  2. Schmalensee, Richard, 1978. "A Model of Advertising and Product Quality," Journal of Political Economy, University of Chicago Press, vol. 86(3), pages 485-503, June.
  3. Milgrom, Paul & Roberts, John, 1986. "Price and Advertising Signals of Product Quality," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 796-821, August.
  4. Kenneth L. Judd & Michael H. Riordan, 1994. "Price and Quality in a New Product Monopoly," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 773-789.
  5. Nelson, Phillip, 1970. "Information and Consumer Behavior," Journal of Political Economy, University of Chicago Press, vol. 78(2), pages 311-329, March-Apr.
  6. Ayca Kaya, 2013. "Dynamics of price and advertising as quality signals: anything goes," Economics Bulletin, AccessEcon, vol. 33(2), pages 1556-1564.
  7. Bagwell, Kyle & Riordan, Michael H, 1991. "High and Declining Prices Signal Product Quality," American Economic Review, American Economic Association, vol. 81(1), pages 224-239, March.
  8. Nelson, Philip, 1974. "Advertising as Information," Journal of Political Economy, University of Chicago Press, vol. 82(4), pages 729-754, July/Aug..
  9. Asher Wolinsky, 1983. "Prices as Signals of Product Quality," Review of Economic Studies, Oxford University Press, vol. 50(4), pages 647-658.
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