Optimal Pricing of Experience Goods

Author(s): Carl Shapiro

Source: The Bell Journal of Economics, Vol. 14, No. 2 (Autumn, 1983), pp. 497-507
Published by: RAND Corporation
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Optimalpricingof experiencegoods
Carl Shapiro*

A monopolist'soptimalpricepath overtime is examinedforsituationsin whichconsumers

initiallymisestimateproductquality and learn about it by using the good. Information
aboutthe productis bundledwith the productitself Two verydifferentcases are studied.
In the optimisticcase, consumersinitially overestimatequality,and the optimal way to
milk a reputationis via a decliningpricepathfollowed by a jump up to a terminalprice.
Thereare no long-runeffectsdue to initial misperceptions.In the pessimistic case, consumersunderestimatequality,and the optimal way to build a reputationis to use a low
introductory
pricefollowed by a higherregularprice. In this case, initial misperceptions
adverselyaffectwelfarein both the short and long run.

1. Introduction
* Whena new productor serviceis introduced,potentialuserstypicallyhave imperfect
informationaboutthe product'sattributes,even thoughthese characteristicsmay be quite
importantto them. An important source of information about the product is actual
experiencewith it. This articleanalyzesthe optimalpricingpolicyof a firmthat introduces
an experiencegood, one that userslearn about throughexperience.'
The sellerof an experiencegood or serviceis necessarilybundlinginformationabout
the productwith the product itself. This applies to anything from restaurantsto legal
servicesor computersystems.Therefore,the seller'sproblemis distinctlya dynamicone:
as buyerslearn about the product,the demand curve shifts over time. In this article,I
investigatethe profit-maximizingdynamic pricing plan for the seller of an experience
good. The transitionpath while consumersare learning,as well as the steady-stateor
long-runbehaviorof the seller,are characterized.This permitsa welfareanalysisof experiencegoods.
Sincethe selleris bundlinginformationwith the product,his strategyis verydifferent
dependingupon whetherthat informationis favorableto him. We thereforedivide the
probleminto two cases:the optimisticcase, whereconsumersinitiallyoverestimateproduct quality, and the pessimistic case where their initial expectationsare too low. We
restrictthe analysisby assumingthat all consumershave the same expectationsof quality;
these expectationsconstitutethe firm'sreputation.
In the pessimisticcase, wherethe true qualityof the productexceeds its reputation,
the firmusesintroductoryoffersto informcustomers.The optimalpolicy is a simpletwo* Princeton University.
I appreciate comments and suggestions by Richard Schmalensee, Steve Salop, a very careful referee, and
Alvin Klevorick which have made the article both clearer and more accurate. Any remaining errors are, alas,
my own.
' The terminology is due to Nelson (1970). In contrast, there are so-called "search" goods, whose attributes
can be determined by inspection without the necessity of use. Many goods have both search and experience
attributes. See Wilde ( 1981).
497

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498 /

THE BELLJOURNALOF ECONOMICS

stagepolicy, a low pricein the firstperiodfollowedby a constanthigherprice.Thereare

adversewelfareeffectsof initial misperceptionsin both the short and long run.
In the optimisticcase the firmengagesin a more complicatedpricingpolicydesigned
optimallyto milk its reputation.There are no long-runeffects of initially incorrectexpectationsin this case. The welfareeffects during the learningprocess are likely to be
mixed;at some point, however,it is optimal to sell more output than is ever sold under
perfectinformation.This constitutesa (temporary)welfareimprovement.
Therearea numberof simplifyingassumptionsthat limit the generalityof the results.
As mentionedabove, we assumethat initial expectationsare identicalthroughoutthe set
of potentialbuyers.To the extent that reputationarises from experiencewith previous
products,this seems quite reasonable.Second, consumers are assumed to have point
expectationsabout the qualityof the product.2This excludesa demand for information
per se: consumerspurchasethe productif and only if they expect it to providepositive
consumersurplus.Third,the learningprocessused in the analysisis very stark:learning
is completeand immediateupon using the producta single time. Finally, it is assumed
that the only sourceof informationabout productqualityis personalexperience.We call
this the case of pure privateinformation.
In practicetherearea numberof sourcesof product-specificinformation:advertising,
reputation,third-partyevaluation(either public or private),signals such as warranties,
word-of-mouthinformation,and personalexperience.Yet many of these sources have
limitations:advertisingis subjectto credibilityproblems,third-partyor word-of-mouth
evaluationsareoften unavailable,and warrantiesare limitedby adverseselectionor moral
hazardproblems.Since personalexperienceis alwaysavailable,the case of pure private
informationseems a useful startingplace.
The articleis organizedas follows. The next section presentsa model of experience
goods and sets out the notation. Section 3 analyzes the pessimistic(or skeptical)case,
while Section 4 treats the optimisticcase. A conclusion follows, which discussesimplications for entry, advertising,and productchoice, and indicatespossibleextensions.

2. The model
* We considera monopolist3who chooses to providea productof qualityq. The bulk
of the article analyzesthe optimal pricingpath, given q. Implicationsfor the choice of
qualityare mentionedin the concludingsection. Let the cost function be c(x, q), where
x is output.We assumethat c eitherhas the usual U-shapedaveragecost shapeor exhibits
constantaveragecosts.
The firm'scontrol variablesare the priceschargedin each period.The model is set
in discretetime, and the pricein periodt is denotedby p,, t = 0, 19 .... The firm'sobjective
is to maximizediscountedprofits,and the interestrate is a constantgiven by r > 0.
Demand is generatedby diverseconsumers,each of whom consumes eitherzero or
one unit of the productper period.Consumersare indexed by their taste for quality,0.
The dollarvalue to a consumerof type 0 of one unit of the productof quality q is given
by Oq.This involves no loss of generality;it simply is a way of definingthe variable0.
Likewise,without loss of generality4we can assume that 0 < 0 < 1 for all consumers.
2 It would be desirableto treatmore generalpriorson the partof consumers,but the addedcomplexity
is greatindeed.Eachconsumer'sstrategywouldbe an optimalcontrolproblem,andconsumerswouldnecessarily
make inferencesabout true qualityfrom the pricecharged.In a ratherdifferentmodel of introductoryoffers,
the inferenceproblemhas been treatedby Farrell(1981). See also Grossman,Kihlstrom,and Mirman(1977).
3 The monopolycan be weak in that it arisesfrom productdifferentiation.
The way in which otherfirms
influencethe problemis discussedbelow.
4 Since qualityhas no naturalscale,we effectivelychoose a scale by settingthe maximal0 at 1.

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SHAPIRO /

499

Hence, a consumerof type 0 who pays p for a product of quality q enjoys consumer
surplus of Oq- p.

Consumersinitiallyexpect the qualityof the seller'sproductto be R > 0; this value

is given by the firm'sor the industry'sreputation.If R = q, there is no learningto be
done, andwe arein the familiar(static)monopolysituation.If R # q, however,consumers
will revisetheirestimatesof qualityif they use the product.We assume that R is a point
expectationso that a consumerof type 0 will purchasethe productinitially if and only
if OR? p, i.e., if and only if
0 ? p/R.
(1)
Consumerdiversityis capturedthroughthe distributionof 0's. Let f(O) denote the
densityfunctionfor 0, and
F(0)=

f(t)dt

(2)

the right-handcumulative:F(O)is the numberof consumerswith taste parameterat least

as high as 0. Then, in view of (1), the initial demandcurveis given by
s(p) = F(p/R).

(3)

In contrast,considerwhat would happen if all consumersknew the true quality q,

ratherthan expectingR. Then demand would be given by the fully-informeddemand
curve,
z(p) = F(p/q).

(4)

Thesetwo demandcurveswill providethe boundariesfor the demandcurvethe firm

faces while consumersare learning.We assume learningoccurs only throughpersonal
experience,as discussedabove. For simplicity,we also assume that learningis complete
and immediateupon use of the product.' With this type of learning,customerscan at
any point in time be divided into two groups:(1) those who have tried the productand
updatedtheir expectationsto q, and (2) those who have yet to try the productand still
expect qualityR. It should be clear that under the assumptionof purely privateinformationthe set of consumerswho have triedthe productis determinedby the lowestprice
previouslycharged.Indeed, the number of consumers who have tried the product is
exactlyF(p/R) if p is the lowest price yet charged.
Viewed in this way, the lowest price previouslychargedis the state variablein the
firm'soptimal control problem,with the control variablesbeing the prices set in each
period. The problem has a structuresomewhat similar to that of intertemporalprice
discrimination,but here consumers(potentially)buy the producteach period.The price
chargedin a givenperiodwill not in generalbe the one that maximizesprofitsthat period;
the firm must account for the effectof this period'sprice on the demand curve in future
periods.
The fact that the state variableis the lowest price yet chargedleads to the following
simplifyingfact:
Lemma 1: In the optimal regimeif PT

? PT-I,

then p, =

PT

for all t ? T.

Proof:If PT 2 PT-1, then the state of the systemdoes not changefrom period T to period
T+ 1,and no newcustomerstrythe productin periodT. Therefore,sincethe environment
is otherwisestationary,if it was optimalto selectPT in period T, it is still optimalto select
PT in period T + 1, and indeed in period t for all remainingt ? T + 1 as well.
In viewof Lemma 1, we need only considerpricepathsthat monotonicallydecline,except
perhapsfor a final price increase.
5This assumption is not critical to the qualitative results, but simplifies the analysis.

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THE BELLJOURNALOF ECONOMICS

The rest of the analysisis very differentdependingon whetherconsumersover- or

underestimatethe seller'squality. Section 3 treats the pessimisticcase (R < q), while
Section4 considersthe optimisticcase (R > q).

3. The pessimistic

case (R < q): building a reputation

* In this section we show that if R < q, the optimal pricingregimeis of the following
two-stageform:a low introductoryprice in the first period followed by a higherprice,
whichis maintainedthereafter.The low initialpriceis chosen to promotethe production
of favorableinformationas well as to generateprofitsin the initial period.
The analysisis significantlyaided by referenceto Figure 1. The figuregraphsthe
followingfunctions:
ir(x, q) = z-'(x)x

c(x, q),

the profitfunction facing fully-informeddemand;

ir(x, R) = s-'(x)x

c(x, q),

the profitfunction facinginitial demand;and

?(x,

xq) =(

r(,R),

x,

x > x,

the profits from selling x units if x customers are informed. We assume that both
7r(x,q) and 7r(x,R) areconcavein x. The ?(x, x) functiontakesthe indicatedformbecause
it is necessaryto sell along the uninformeddemand curve to attractnew (uninformed)
consumers.
Denote by x*(R) the sales level that maximizesprofitsfacingcommon expectations
R (i.e., demand s(p)), and denote by x*(q) the profit-maximizingsales level facing fully
informeddemand, z(p). Let ir*(R)and lr*(q)denote the correspondingprofit levels. It
is not difficultto show that x*(q) exceedsx*(R). The reasonis that the marginalrevenue
schedule under the (lower)uninformeddemand is everywherelower than the marginal
revenue schedule under fully informeddemand.6As a consequence,the marginalcost
curvemust intersectthe uninformedmarginalrevenuecurvefirst,at a lowerlevel of sales,
than it intersectsthe fully informedmarginalrevenuecurve. The firstintersectiondetermines x*(R), and the second gives x*(q), so that x*(q) > x*(R). This implies that the
profitcurvesare indeed as shown in Figure 1.
Our aim is to show that the optimalpricingprogramis of the followingform, which
we call a two-steppricing regime. In the initialperioda low price,PL, is charged,generating
salesof x = S(PL) In all futureperiods,the priceis set as highas possiblewhile maintaining
sales of S(PL). This involves a higherprice of PH = Z- (X) = Z-'(S(PL)). Sales are constant
in all periods.
The idea behind such a programis to make an introductoryoffer (PL) to inform
customersabout the true quality,q, which is in excess of the expectedquality,R. After
the initialperiod,priceis raisedto takeadvantageof the new, more favorableinformation
consumersnow possess.
The tradeoffin selectingx is between (a) sacrificingprofitsin the initial period by
settingx largerthan x*(R), and (b) earningmore profitsin subsequentperiodsby raising
x closer to x*(q). In view of this tradeoffwe have the followinglemma.

given by p = z-'(x) = qF-'(x). The uninformedinverse

demandcurve is p = s-'(x) = RF-'(x). Since these two curvesare multiplesof each other, so are the correspondingmarginalrevenuecurves. The informedand uninformedmarginalrevenuecurves are relatedby
MRz(x) = (q/R)MR/(x), so that the informedcurve lies everywhereabove the uninformedone.
6 The fully informedinversedemandcurve is

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SHAPIRO /

501

FIGURE 1
PROFITS IN THE CASE R'q

7T(q)~~~~~~~~~~~~~~~~Tq

7T (R)>/

(X,R)

x (R)

x(q)

Lemma 2: Among all two step regimes, the optimal regime has sales x where
x*(R) < x < x*(q).

Proof:Profitsunder a two-step regime are given by V(x) = 7r(x,R) + ?(x, x)/r. Since
?(x, x) = rr(x, q), we have V(x) = 7r(x,R) + 7r(x,q)/r. Differentiatingwith respectto x
gives V'(x) = 7r,(x,R) + 7r,(x,q)/r. The first term is positive if and only if x < x*(R),
while the second term is positive if and only if x < x*(q). For the optimal x, V'(x)= 0,
and the two terms must sum to zero. This requiresthat x*(R) < x < x*(q).
It is optimalto sell morethanx*(R) to augmentfuturedemand.Informingcustomers
is costly in terms of first-periodprofits,however,so that it is not optimal to inform so
many customersas one would choose to sell to under perfectinformation,i.e., x*(q) of
them. If learningby consumersis slow, i.e., if r is large,x will be close to x*(R).
We next show that two-stepregimesareoptimal.By Lemma 1 we need only consider
pathswith monotonicallydeclining prices followed (perhaps)by a final pricejump. In
fact, monotonicallydeclining prices cannot be optimal because declining prices imply
that the selleris operatingalong the uninformeddemand curve and such a policy could
be dominatedby simply earning r*(R) each period.
Considerthen a price path that declines until period T, at which time the price
increasesto PT. Call XT the ultimate sales level; XT = Z(PT). The penultimateprice is
denotedby PT-I. Now it is easy to see that any decliningpricingsequenceending with
PT-I at date T - 1 and rising to PT thereafteris dominated by earning r*(R) for
t < T - 1, followed by chargingPT-I and then PT thereafter.Therefore,we need only
considera numberof periodsof earning r*(R) followedby chargingPT-I and then PT.
The point of settingPT-I lower than previouspricesis to inform futurecustomers,since
PT- I generateslowerprofitsin period T - 1 than wereavailableat earlierdates.Therefore,
if the programis to be optimal, it must involve selling in period T to all those who are
informed,i.e., XT_1 = XT, so that the regimestartingat date T - 1 is a two-steppricing
regime.The proposedprogramthus consists of earning ir*(R)for a numberof periods,
followedby a two-stepregime.But such a mixed regimecannot be optimal:if the two-

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502

THE BELL JOURNAL OF ECONOMICS

step regime is ultimately optimal, then it is optimal to impose it at once.7 This proves
the following theorem.
Theorem 1 (Introductory Offers): When consumers underestimate quality, the optimal
pricing path is a two-step pricing regime with a low introductory price followed by a
higher price which is maintained thereafter. The sales level is constant over time, and lies
strictly between the monopoly sales level facing the uninformed demand, x*(R), and that
facing the informed demand, x*(q).
The optimality of two-step regimes is a consequence of the complete and immediate
learning by consumers when they try the product a single time. If consumers updated
their expected quality estimate, R, gradually in the direction of the true quality, q, a more
complex regime would arise. If the updating takes n periods, then the optimal regime is
an (n + 1)-step regime with constant sales and a price gradually increasing throughout
the learning process.
In view of Theorem 1, it is very easy to perform a welfare analysis in the case of initial
underestimates of quality. The welfare measure used is consumer surplus plus profits.
Theorem 2: When consumers underestimate quality, there are long-run welfare losses
from initial misperceptions because the long-run sales level is lower than that under
perfect information, x*(q). Since this sales level also prevails in the first period, there are
welfare losses in the short run as well.
It is interesting to recognize that the monopolist's incentives to increase his reputation
coincide with social objectives, at least in the range where R < q. Clearly, however, the
monopolist's profits are increasing in R, while social welfare need not be when R > q.
It is that case, the optimistic case, to which we now turn.

4. The optimistic case (R > q): milking a reputation

* When consumers overestimate product quality (R > q), the analysis, as well as the
form of the optimal pricing regime, is entirely different from that in the pessimistic case
except that Lemma 1 still applies. In the pessimistic case, the firm valued initial sales
positively because the information was favorable to it. In the optimistic case the seller
faces a very different tradeoff: more sales today cause more unfavorable information to
be produced, since information is bundled with the product. As a consequence, the seller
engages in a dynamic price reduction strategy of optimally milking his reputation without
letting the unfavorable information get out too quickly. This analysis is applicable to a
seller who has reduced his quality after establishing a reputation of R.

7By Lemma 1 we need only consider a single period earning 7r*(R)followed by the two-step regime. After
all, if it is optimal to set the same price twice, it must be optimal to do so forever, and it certainly is not optimal
to earn 7r*(R)forever (by Lemma 2). Let V be the present discounted value of the optimal two-step regime. If
7r*(R)for one period followed by V is optimal, then, setting p = 1/(1 + r),

7*(R)+pV?

so that
7.*(R) 2 V(1 - p).
But V is strictly superior to earning 7r*(R)forever (since even the inferior two-step regime with x
better than that) so that
VT

r*(R)f l

by V cannot*(Rb

I - p

This is a contradiction, proving that 7r*(R)followed by V cannot be optimal.

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x*(R) does

SHAPIRO / 503
Denote by x(p, p) the demandcurve when p is the lowest price previouslycharged.
A majordifferencebetweenthis case and that of R < q is that the consumerswilling to
pay the most for the productneed not be those who value it the most. Rather,they may
be those who did not value it enough to try it at p and thereforestill expect R > q. The
informedcustomers,on the other hand, while having high 0's, have lower expectations,
and hence lower reservationprices.
We must, thereforedistinguishtwo subcasesin describingx(p, p): Case A, where
q
pf> and Case B, where pj < q.
Case A: R > q and ff> q. Case A is depictedin Figure2. The demand curves s(p) and
z(p), definedby (3) and (4), are drawnas they must be when R > q. There are x = s(j3)
informedcustomers,whosedemandis depictedby the segmentqB along z(p) in the figure.
The remainingconsumers'demands are capturedin the portion of s(p) which is still
applicable,namelyAF. Summingthese horizontally,we have x(p, p), shown as the heavy
line in Figure2.8
In this case the consumerswith highestreservationprice are those who marginally
chose not to purchaseat p. Once p < q, some informeddemand arises,while for prices
lowerstill demandis along the uninformeds(p) curve.
Case B: R > q and p < q. In this case the consumerswith highestreservationpricesare
the informedconsumerswith 0 = 1. The curvex(p, p) is drawnin Figure3. Again there
are x = s(j3)informedbuyers.The informeddemand is the segment qB along z(p), and
the uninformeddemand is the segment AF along s(p). Again summing horizontally,
FIGURE 2
x(p,p) WHEN R>q AND p>q
PA
R

p
q

x AS(p)
Fp/)
=

_~~~~~~~~G

q t
z(p)

F(p/q)

FF

s(p)

Formally, we have for Case A

p? 3

s(p) - s(p3)
s(p) - s(p) + z(p)

Z-'(s(0)) < p < q

q< p <

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No~~x

504 /

THE BELLJOURNALOF ECONOMICS

FIGURE 3
x(p,p)

WHEN R>q AND q>p

PA
R

s (p)

\\A\x

(p,

P)

Pp---(P
tp)

ox
F

x= s(p)

x(p, pj) is shown as the heavy curve in Figure 3.9 Notice that even though both s(p) and
z(p) exhibit declining marginal revenue, x(p, p) need not.

O The optimal pricing regime when R > q. Now we can proceed to analyze the optimal
pricing sequence {p,} chosen by the monopolist. The major result is Theorem 3.
Theorem 3: When consumers overestimate quality, the optimal pricing path is of the
following form. Price declines monotonically, eventually reaching a lower price and higher
level of sales than would occur under perfect information. Then the price and quantity
revert to the same levels that would prevail under perfect information, and remain there
subsequently.
Proof By Lemma 1 we need only consider pricing paths of the following two types: Type
I paths of the form p, - P2 ? . . ., and Type II paths of the form
PI > P2 > .

> PT-1I< PT = PT+1I= . .

The proof consists of showing that: (a) Type I paths are all suboptimal and (b) to be
optimal, a Type II path must have PT = P*, the price which maximizes profits facing the
informed demand curve, and PT-I less than p*.
The key to the proof is to realize that in the long run the firm will be operating on
(in the case of Type II paths) or arbitrarily close to (in the case of Type I paths) the
informed demand curve, z(p).
For the purposes of the proof, define 7r(p) = pz(p) - c(z(p), q), the profits from
selecting price p under perfect information. Let 7r*= 7r(p*),the maximal profits attainable
facing the informed demand curve.
9 Formally, in Case B
0
X(P,

Z(p)

Z(p) + S(P) - SOP)

I
S(p

pp
Z-,(S(pi))
P <

p
< p < pi
1
')."

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SHAPIRO / 505
We first prove part (a). For Type I paths, call the limiting pricef. In the limit the
firm is earningprofits(per period)of X = 7r(f). If f # p*, then i < ir*. Yet in all cases
at any pricep, the demandunderimperfectinformation,x(p, pf)is at least as greatas the
perfectinformationdemand,z(p). Therefore,it is alwaysfeasibleto earn lr* everyperiod.
To continue to earn ir < r* cannot be optimal.
If p = p*, the argumentis more subtle.The limitingdemandcurve,x(p, p*) is shown
in Figure4, alongwith its marginalrevenuecurveand the fullyinformedmarginalrevenue
curve.Note that,as drawnin the figure,p* is necessarilylessthanq. Althoughp* maximizes
profitsfacingdemandz(p), a lowerpricemaximizesprofitsfacingx(p, p*) becausea lower
priceexploitssome overoptimisticconsumers(whowill not purchaseat p = p*). Therefore,
the sellercan improveon the Type I path with f = p* by deviatingfor, say, one period
to a pricebelow p* and earningextra profitsas shown by the shaded area in Figure4.
This provesthat a Type I path withf = p* cannot be optimal.
Turningto Type II paths, it is immediatethat the final price PT must equal p*. If
did
not equalp*, then long-runprofitsper periodwould fall short of 7r*.This cannot
PT
be optimal,since it is alwaysfeasibleto earn at least 7r*in any given period.
It remainsonly to show that the penultimateprice,PT-I, is less than p*. Yet this is
immediatesince PT = P* and PT-I is less than PT by the definitionof a Type II path.
Theorem3 showsthat the firmwill graduallymilk its reputationby reducingits price
over time. It is interestingto note that this processwill continue past the point p, = p*:
it pays for the firm to sell to some overoptimisticbuyerswho will not be served in the
long run once they learn the true qualityof the product.

FIGURE 4
DEMAND AND MARGINAL REVENUE WHEN

=
p

PA
R

x~~ MR~1~~1

PI

MRX(PP

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506 /

THE BELLJOURNALOF ECONOMICS

The welfare effects along the transition path are mixed. Initially sales will be low as the
seller sets high prices in an effort to reduce the production of unfavorable information.
At some point, however, sales exceed their perfect information level; this represents a
welfare gain, at least a temporary one.
In the long run the seller returns to p* and all consumers who purchase are informed,
so that we have:
Theorem 4: When consumers initially overestimate quality, there are no long-run effects
of their misperceptions on either profits or consumer surplus.

5. Conclusions and extensions

* The optimal monopoly pricing policy for experience goods has been analyzed for the
case in which consumers have identical initial point estimates of the product's quality
and consumers learn quality immediately and fully from a single experience with the
product. The two cases of initial over- and underestimates of quality are qualitatively very
different.
When consumers underestimate quality, the seller initially values sales for two reasons: their contribution to current profits and their joint product, favorable quality information, which augments future demand. The seller can mitigate the problems of skeptical consumers by using a low introductory price, and it is optimal to do so."' The seller's
optimal policy consists of a low introductory price followed by a higher price which is
maintained forever. Nonetheless, adverse welfare effects of misperceptions persist. In the
long run, owing to consumers' initial skepticism, the monopolist sells to fewer customers:
it is costly in terms of initial profits to attract and inform consumers.
When consumers overestimate quality, there are no long-run effects of misperceptions
on either prices or sales levels. A surprising result is that in such cases, at least during
some period of the learning process, the seller finds it optimal to sell more than under
perfect information. Therefore, the welfare effects of overestimates of product quality are
different at different stages in the optimal pricing program.
Both quality and reputation were exogenously given in the model. Clearly, the quality
choice problem for a seller facing a given reputation has as a subproblem that of the
optimal pricing regime studied here. Given the cost schedule in quantity and quality,
c(x, q), and the solution to the optimal pricing regime for each given quality, the optimal
quality choice problem can be solved. A general principle (Shapiro, 1982) is that quality
incentives are suboptimal when reputations have value.
Advertising policy can also be studied by using these results. For example, advertising
may increase consumers' willingness to try the product, i.e., it may change R. The value
of such reputation enhancement depends on the associated pricing policy. In the case of
underestimates of quality it is particularly easy to determine the value of increasing R.
Since the optimized present value of profits is given by V(x, R) = ir(x, R) + 7r(x, q)/r, by
the envelope theorem, once x is optimized, VR(X,R) = 7rR(x, R).
It would be quite interesting to extend the results beyond the monopoly case. In
practice, the initial reputation, R, that a firm enjoys when it introduces a new product
depends both on the previous products it has produced and on the qualities of its competitors' products. Such spillovers can lead to suboptimal quality choices. Whether imperfect information leads to entry barriersis a more complex question, since new entrants
can always duplicate the qualities of existing brands (but see Schmalensee (1982)).

to

This result might be limited if consumers use a low price as a signal of low quality. Yet the signal need
not work that way: it is the highest quality sellers who most value informing new consumers of their product's
virtues, and who therefore may set the lowest initial prices!

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SHAPIRO

507

The featuresof seller behaviorthat arise when product informationis implicitly

bundledwith the productitself are an importantpart of studyingthe supply side of the
marketfor information.It is highly desirableto extend the resultsin this articleto situations in which consumers'demands explicitly include the demand for information
aboutthe product.Modelsin whichthe firm'sactions,eitherpricingor advertising,signal
consumersabout its qualityare anothernaturalextension.
References
J. "Introductory Offers with Ultrarational Consumers." Unpublished manuscript, M.I.T., 1981.
S., KIHLSTROM, R., AND MIRMAN, L. "A BayesianApproachto the Productionof Information
and Learning by Doing." Review of Economic Studies (October 1977), pp. 533-547.
NELSON, P. "Information and Consumer Behavior." Journal of Political Economy (March 1970), pp. 311-329.
SCHMALENSEE, R. "Product Differentiation Advantages of Pioneering Brands." American Economic Review
(June 1982), pp. 349-365.
SHAPIRO, C. "Consumer Information, Product Quality, and Seller Reputation." Bell Journal of Economics
(Spring 1982), pp. 20-35.
WILDE, L. "Information Costs, Duration of Search, and Turnover: Theory and Applications." Journal of Political
Economy (December 1981), pp. 1122-1141.
FARRELL,

GROSSMAN,

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