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Reexamining the Schmalensee effect

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  • Kim, Jeong-Yoo

Abstract

The author reexamines 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 author argues 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 author characterizes 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.

Suggested Citation

  • Kim, Jeong-Yoo, 2017. "Reexamining the Schmalensee effect," Economics Discussion Papers 2017-3, Kiel Institute for the World Economy (IfW).
  • Handle: RePEc:zbw:ifwedp:20173
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    References listed on IDEAS

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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.
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    5. 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.
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    7. Nelson, Philip, 1974. "Advertising as Information," Journal of Political Economy, University of Chicago Press, vol. 82(4), pages 729-754, July/Aug..
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    experience good; quality; signal; Schmalensee effect;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • L15 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Information and Product Quality

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