Premiums for High Quality Products as Returns to Reputations

TLDR

In markets where buyers cannot observe quality, sellers are incentivized to cut quality for short‑run gains before buyers notice. The paper derives an equilibrium price‑quality schedule for such markets and studies how improved consumer information and a minimum quality standard affect it. The schedule sets a premium for high‑quality items above cost to deter quality cutting, and the analysis examines the impact of better information and a minimum standard on this premium. The premium compensates sellers for reputation investment, yet optimal quality standards also exclude some items that consumers would like to buy.

Abstract

This paper derives an equilibrium price-quality schedule for markets in which buyers cannot observe product quality prior to purchase. In such markets there is an incentive for sellers to reduce quality and take short-run gains before buyers catch on. In order to forestall such quality cutting, the price-quality schedule involves high quality items selling at a premium above their cost. This premium also serves the function of compensating sellers for their investment in reputation. The effects of improved consumer information and of a minimum quality standard on the equilibrium price-quality schedule are studied. In general, optimal quality standards exclude from the market items some consumers would like to buy.