Signaling Quality Through Horizontal Disclosure in a Hotelling Model

2012 
The paper studies the role of advertising in markets with products differentiated both vertically (different quality) and horizontally (different personal match) where the producer is not able to credibly communicate the quality of the good. We create and analyze a model where the producer chooses whether to advertise or hide personal match and this decision depends on the second dimension, which is internal quality of the good. We show that under certain assumptions there exists a separating equilibrium where the company that produces high quality product chooses to advertise 'match' (horizontal characteristics), while the company that produces the standard quality product chooses to hide the horizontal characteristics. By advertising the horizontal characteristics the company creates additional differentiation in the valuation of the good by consumers. We assume that by advertising 'match' the company does not create additional value in aggregation, however, creates extra value for some customers. A certain group of consumers understand that this product is designed specifically for them, while others realize that there are characteristics they do not like. As a result, the valuation for some consumers increases while the valuation of others decreases. In other words, the 'match advertising' leads to the rotation of the demand curve. The choice whether to advertise the match or not is endogenous and based on the quality of the good the company produces and on the production cost. We first show that the firm with high quality and high production cost benefits more from match advertising because it needs to concentrate on a narrow market with a very high price. Advertising will further increase quality for a narrow group of customers, and will allow the manufacturer to charge higher price. At the same time, the firm with low quality will concentrate on a wide market, because market contraction will hurt this firm. Second, we show to separate itself from the low quality firm the high quality firm might need to increase the price higher than the perfect information price. If the price is low enough the possibility to mimic the behavior of the high-quality firm may be attractive for the low quality firm. The customers will believe that this product is of high quality and will pay more. To separate themselves from the low quality firm the high quality firm needs to increase the price, forgoing some profit due to loss of customers. However, mimicking the company that concentrates on a very narrow market will be unprofitable for the low quality firm, and, therefore, the separation is achieved. Third, we find the parameter region where the separation is achieved without any distortions. Contrary to other results we show that high quality firm sometimes does not have to set its price higher than the perfect information price in order to signal the high quality of the product.
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