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Product Quality Signaling in Product Quality Signaling in Experimental MarketsExperimental Markets

ROSS M. MILLER; CHARLES R. PLOTT; ROSS M. MILLER; CHARLES R. PLOTT; Econometrica; Econometrica; Jul 1985; 53, 4Jul 1985; 53, 4

Presented by Kelly GoldsmithPresented by Kelly Goldsmith

03/02/200503/02/2005

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IntroductionIntroduction

My interest in Quality My interest in Quality Signaling originally Signaling originally stemmed from the stemmed from the idea of companies idea of companies “Burning Money” to “Burning Money” to signal their quality to signal their quality to customers…customers…

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Example: Super Bowl CommercialsExample: Super Bowl Commercials

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Intuition:Intuition:

People see ads during the Super Bowl and People see ads during the Super Bowl and realize how expensive they arerealize how expensive they are

Even though the ads reveal little to no Even though the ads reveal little to no information about the product, consumers view information about the product, consumers view them and believe the seller is high qualitythem and believe the seller is high quality

Why? The seller must be successful to afford Why? The seller must be successful to afford such an ad – and to be successful many others such an ad – and to be successful many others must have purchased the good!must have purchased the good!

Implied: Others would not have purchased the Implied: Others would not have purchased the good, had it not been high qualitygood, had it not been high quality

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Product Quality Signaling Through Product Quality Signaling Through Pricing: Miller & PlottPricing: Miller & Plott

Generated and Generated and manipulated manipulated experimental experimental “markets” to explore “markets” to explore the possibility that the possibility that sellers could extract sellers could extract information from the information from the buyers by becoming buyers by becoming aware of aware of Quality Quality Signals Signals

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The Experiment: SellersThe Experiment: Sellers Possessed commodities exogenously designated as Possessed commodities exogenously designated as

“regular” or “super”“regular” or “super” Though the grade of the commodity changed, at all times Though the grade of the commodity changed, at all times

half the sellers had “regulars” and half had “supers”half the sellers had “regulars” and half had “supers” Could add units of quality which would be observed (and Could add units of quality which would be observed (and

valued) by buyersvalued) by buyers Each unit of quality came at a cost to the sellerEach unit of quality came at a cost to the seller Adding quality to a “regular” was more costly than adding Adding quality to a “regular” was more costly than adding

quality to a “super”quality to a “super” Sellers had two units to sell, so that total quantity was Sellers had two units to sell, so that total quantity was

fixedfixed After the period was over the grades of the sellers’ After the period was over the grades of the sellers’

commodities were revealedcommodities were revealed

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The Experiment: BuyersThe Experiment: Buyers

Received a “bonus” for purchasing at least one Received a “bonus” for purchasing at least one commodity; did not have budget restrictionscommodity; did not have budget restrictions

They valued “supers” over “regulars” They valued “supers” over “regulars” Had no information prior to purchase as to the Had no information prior to purchase as to the

grade of the commoditygrade of the commodity Had the incentive to look for Quality Signals to Had the incentive to look for Quality Signals to

help them intuit the grade of the goodhelp them intuit the grade of the good All buyers had identical redemption value All buyers had identical redemption value

functionsfunctions

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The Experiment: BuyersThe Experiment: Buyers

Redemption Value Function

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Graph of Unit Demand and Cost:Graph of Unit Demand and Cost:

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Experimental DesignExperimental Design

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Miller & Plott Manipulations:Miller & Plott Manipulations:

The authors tried a variety of manipulations:The authors tried a variety of manipulations:1) The cost of adding quality to a “super” at low v. 1) The cost of adding quality to a “super” at low v.

high cost to the sellerhigh cost to the seller2) The bonus for purchasing one unit2) The bonus for purchasing one unit3) Prices were in Francs, not dollars: the 3) Prices were in Francs, not dollars: the

manipulated the value of a Francmanipulated the value of a Franc4) Degree to which the grade of the commodity 4) Degree to which the grade of the commodity

(post sale) was made salient(post sale) was made salient With all these different manipulations, several With all these different manipulations, several

models were required to explain their resultsmodels were required to explain their results

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Theoretical Models:Theoretical Models:

The Full Information ModelThe Full Information Model The Naïve ModelThe Naïve Model The Pure Pooling ModelsThe Pure Pooling Models The Partial Pooling ModelThe Partial Pooling Model The Most Efficient Signaling Equilibrium The Most Efficient Signaling Equilibrium

and Rothschild-Stiglitzand Rothschild-Stiglitz Inefficient Signaling EquilibriaInefficient Signaling Equilibria

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Theoretical Predictions of Models:Theoretical Predictions of Models:

Most models predict: Most models predict:

1)1) All “regulars” will sell at the same price/quality All “regulars” will sell at the same price/quality

2)2) All “supers” will sell at the same price/qualityAll “supers” will sell at the same price/quality

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Today’s Experiment:Today’s Experiment:

Had a low cost for adding quality to a Had a low cost for adding quality to a “super”“super”

Held the bonus for purchase constantHeld the bonus for purchase constant Used dollars in stead of Francs (thus Used dollars in stead of Francs (thus

constant value)constant value) Made the grade of the commodity (post Made the grade of the commodity (post

sale) salientsale) salient

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Their Findings:Their Findings:Parallel Experiment - #2Parallel Experiment - #2

Their results found that Signaling Their results found that Signaling Equilibrium models apply hereEquilibrium models apply here

Studied results as a function of Excess Studied results as a function of Excess Value and Quality of salesValue and Quality of sales

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Discussion of Excess Value:Discussion of Excess Value:

Excess Value = X (q) = P (q) – V (R , q)Excess Value = X (q) = P (q) – V (R , q) The maximum possible loss a buyer can The maximum possible loss a buyer can

face when purchasing a unit of quality, qface when purchasing a unit of quality, q Reflects the buyer’s confidence that the Reflects the buyer’s confidence that the

unit is a “super”unit is a “super” It is the amount paid It is the amount paid overover the unit’s value the unit’s value

as a “regular”as a “regular”

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Experiment 2: ResultsExperiment 2: Results

Super

Super

Mean Excess Value Mean Quality

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Conclusions from Parallel Conclusions from Parallel Experiments:Experiments:

1)1) Quality Signaling occurs when the Quality Signaling occurs when the marginal cost of signaling a “super” is marginal cost of signaling a “super” is relatively lowrelatively low

Signaling Models StateSignaling Models State: The Excess Value : The Excess Value of supers should be near $2.00 and the of supers should be near $2.00 and the Excess Value of Regulars should be Excess Value of Regulars should be slightly below zeroslightly below zero

2) Experiment 2 displayed these predicted 2) Experiment 2 displayed these predicted equilibria (p=.05)equilibria (p=.05)

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Which Model Best Fits the Data?Which Model Best Fits the Data?

The Inefficient Signaling Equilibrium The Inefficient Signaling Equilibrium Model:Model:

Predicts super quality above 27 unitsPredicts super quality above 27 units

Direction of movement in Experiment #2 Direction of movement in Experiment #2 indicates quality levels are moving towards indicates quality levels are moving towards the the most efficientmost efficient signaling equilibrium signaling equilibrium

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Conclusions:Conclusions:

Signaling is a real phenomenonSignaling is a real phenomenon The notion of equilibrium is appropriateThe notion of equilibrium is appropriate The most efficient signaling equilibrium will The most efficient signaling equilibrium will

emerge, if given timeemerge, if given time

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Critique of Conclusions:Critique of Conclusions:

Essentially, the authors ran several Essentially, the authors ran several very very differentdifferent experiments by using a variety of experiments by using a variety of manipulationsmanipulations

As it stands, it appears they use six As it stands, it appears they use six different models to predict results – when different models to predict results – when you have six models to chose from, one is you have six models to chose from, one is bound to be correct!bound to be correct!

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Improvements on Design:Improvements on Design:

Relating to the earlier idea of “burning money”: it Relating to the earlier idea of “burning money”: it would have been nice to see an analysis of how would have been nice to see an analysis of how sellers made sellers made all their offersall their offers rather than just an rather than just an analysis of the successful transactionsanalysis of the successful transactions

Reputation Building: While the paper gives a nod Reputation Building: While the paper gives a nod to the fact that, in an experiment such as this, to the fact that, in an experiment such as this, reputations can be built; it would be very reputations can be built; it would be very interesting to run the experiment with interesting to run the experiment with anonymous sellers and see if the results were anonymous sellers and see if the results were maintainedmaintained

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THANK YOU!THANK YOU!

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If You’re Interested in Learning If You’re Interested in Learning More about Quality Signaling:More about Quality Signaling:

““Price and Advertising Signals of Product Price and Advertising Signals of Product Quality” by Milgrom & Roberts (1986)Quality” by Milgrom & Roberts (1986)

An Introduction to Game Theory An Introduction to Game Theory (Osborne) : p. 350 – 357(Osborne) : p. 350 – 357

The Theory of Industrial Organization The Theory of Industrial Organization (Tirole) : p. 106 - 115(Tirole) : p. 106 - 115