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Quality signaling when the Market moves from a Monopoly to a Duopoly. Experimental Economics Sumon Datta. Advertising. Dissipative advertising / Burning money – Signal for quality Informative advertising - raising awareness Response curve – S-shaped; Saturation; Irritating. Pricing.
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Quality signaling when the Market moves from a Monopoly to a Duopoly Experimental Economics Sumon Datta
Advertising • Dissipative advertising / Burning money – Signal for quality • Informative advertising - raising awareness • Response curve – S-shaped; Saturation; Irritating.
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) Price Period
L H Incumbent H entrant L entrant H L incumbent
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: 3rd 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.
