CAN Low PRICE SIGNAL HIGH QUALITY?
EXPERIMENTAL EVIDENCE
by
N. DAWAR*
and
M. SARVARY**
96/91/MKT
*
Assistant Professor of Marketing at INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex,
France.
**
Assistant Professor of Marketing at Graduate School of Business, Stanford University, Stanford, CA
94305-5015, USA.
A working paper in the INSEAD Working Paper Series is intended as a means whereby a faculty researcher's
thoughts and findings may be communicated to interested readers. The paper should be considered
preliminary in nature and may require revision.
Printed at INSEAD, Fontainebleau, France.
Can Low Price Signal High Quality? Experimental Evidence
NirajDawar
and
Miklos Sarvary
Niraj Dawar is Assistant Professor of Marketing at 1NSEAD, Fontainebleau, France, currently on leave at
the Richard Ivey School of Business, University of Western Ontario, London, Ontario, Canada, N6A 3K7.
Miklos Sarvary is Assistant Professor of Marketing, Graduate School of Business, Stanford University,
Stanford, CA 94305-5015. The authors thank John Hulland, Lydia Price, and Priya Raghubir for convents
on earlier drafts.
Can Low Price Signal High Quality? Experimental Evidence
Abstract
Economic signaling theory suggests that consumers interpret the price signal within the context
of market conditions. Under specific conditions it predicts that low price may signal high
quality. Results from an experiment designed to test the behavioral assumptions underlying
this prediction indicate that consumers intentions to purchase conform to the predictions of
economic signaling theory, but their judgments of product quality do not. The results suggest
that consumers' response to signals may be more complex than previously shown.
1. Introduction
Signaling games are often used to describe situations characterized by asymmetric
information about product quality between firms and customers (see Chu 1993 for an example in
marketing). On the assumption that consumers and firms are rational and capable of interpreting
each other's moves, signaling games specify market conditions under which firms can resolve
information asymmetry and deliver product quality information to consumers through, for
example, price or weight of advertising. Consumers update their beliefs about product quality by
observing and interpreting these signals within the context of market conditions.
The objective of economic signaling studies is to determine equilibrium market outcomes.
However, a challenging and important task for consumer research is to understand consumers' ex
post quality perceptions or, more generally, the behavioral outcome of signaling games. Previous
research has examined and found support for signaling theory's assumptions about the effects of
advertising expenditures and warranties on consumers' perceptions of quality (Kirmani 1990;
Kirmani and Wright 1989; Boulding and Kirmani 1993).
The present paper contributes to this research by focusing on price as a signal.
Specifically we examine a set of market conditions in which signaling theory predicts that low
price may signal high quality. We study consumers' perceptions of product quality and their
intentions to purchase based on different prices in the context of a specific price-signaling game
proposed by Nelson (1970) and Schmalansee (1978). Our objective is to test the predicted
behavioral outcomes of this game. Unlike previous consumer research, we do not find complete
support for the predicted outcomes. A key result of our study is that while the relevant behavioral
variable, "intention to purchase," is consistent with the predictions of the Nelson-Schmalansee
game, quality perceptions are not. The findings suggest that the behavioral outcomes of economic
signaling games may be more complex than previously expected.
1
In the next section we describe the specific Nelson-Sclunalansee game which we test.
Based on this game, we develop hypotheses regarding the relationships between price, perceived
quality and intentions to purchase for the different market conditions. Section 4 describes the
experiment and Section 5 discusses the implications of the results.
2. The Nelson-Schmalensee game: the case of introductory pricing
Where consumers are faced with a new product for which quality is unobservable and can
only be assessed through consumption ("experience good"), Nelson (1970, 1974) suggested that
"wasteful" expenditures by firms (such
as very low introductory prices or an expensive advertising
campaign) may signal high product quality in a repeat purchase context. From such signals consumers
infer that the firm is confident of repeat business for the product and is willing to forego current
profits in exchange for future returns. A low quality producer on the other hand is unable to follow the
same strategy because of the low likelihood of repeat purchases.' For the high quality firm this "lowprice" strategy results in current losses which can be viewed as the cost of signaling. If future gains
for the high quality firm from repeat business are likely to compensate for and exceed the short term
losses due to low introductory pricing, there exists a
separating equilibrium in which a low price
2
signals high quality. Under such market conditions, from a low price consumers infer high product
quality. In the opposite case, where long term gains cannot cover short term losses, both high and low
quality firms follow the same pricing strategy and we have a
pooling equilibrium. Under such market
conditions, prices only reflect average quality on the market (consumers' priors) and consumers do not
learn about product quality at all. In a third market condition, unexplored by economic signaling
theory, market information available to consumers may be insufficient to determine whether short term
losses can be recovered by firms in the long run. In this case market conditions are silent on the
relationship between price and quality and consumers remain uncertain of it.
2
It is important to note that the predictions of this specific signaling game (see Tirole, 1992 for
a simple formulation) are based on the following assumptions: (1) the product is an "experience good"
that is (2) repeatedly purchased; (3) low quality must not be profitable under full information, i.e. if
consumers knew the quality of the product prior to purchase they would not buy the low quality
product even if it were cheaper, and finally, (4) there is no consumer heterogeneity in preferences (i.e.
consumers have roughly the same utility for the product). The third assumption is particularly
important for the design of our empirical test. It ensures that in the context of this game purchase
behavior is entirely driven by quality perceptions. Thus, in our experiment we expect, within an
acceptable price range, the effect of price to be identical on intentions to purchase and perceptions of
quality. Hypothesis for each of the market conditions outlined here are developed in the next section.
3. Hypotheses
The theory predicts an interaction of price with market condition on consumer behavior
(intentions to purchase and perceptions of quality). The specific effects predicted in each of the
market conditions are described below.
1.) Consumers are able to assess that signaling high quality with a low introductory price is
possible: under this condition, the market environment carries sufficient information for
consumers to assess that a high quality producer may be able to signal quality with a low
introductory price and make up for the current loss of profit by securing a high level of repeat
purchase in the future. This condition is labeled the Separating condition. In this situation,
economic signaling theory predicts that judgments of quality and intentions to purchase are
negatively related to price.
Hi:
When market conditions indicate that signaling quality with a low price is possible,
judgments of quality and intentions to purchase are negatively related to price.
3
2.)Consumers are able to assess that signaling quality with price is not possible:
If consumers
have sufficient information to assess that future gains will not compensate good quality firms for
current losses they incur from introductory low prices, they can be certain that the price signal is
ineffective. Economic signaling theory predicts that both types of firms (low and high quality) will
choose similar prices. This price reflects consumers' (aggregate) prior expectation of quality on
the market. Thus, a higher price indicates that the market evaluates that the expected quality is
also higher. Therefore, we can expect a positive relationship of judgments of quality and
intentions to purchase with price. This market condition is labeled the Pooling condition.
112: When market conditions indicate that price signaling is not possible, judgments of
quality and intentions to purchase are positively related to price.
3.)Consumers are unable to assess signal effectiveness:
If essential pieces of information
required to interpret the price signal are unknown, the effectiveness of the signal is uncertain. For
example, if the future prospects of a nascent industry (and consequently the ability of firms to
benefit from repeat sales) are not known, consumers do not have sufficient information to assess
whether price is an effective signal. Consistent with the logic of signaling theory, under these
circumstances we would expect to observe no systematic relationship between price and perceived
quality or intentions to purchase the product We label this condition the Uncertain condition.
H3: When there is insufficient information to assess the effectiveness of the price
signal, judgments of quality and intentions to purchase are not related to price.
4.
Experiment
The theory predicts that consumers interpret price based on market conditions, and that we
should expect a negative, positive or no relationship between price and quality judgments
depending on these market conditions. The following experiment is designed to test these
predictions.
4
4.1 Design and Stimulus Materials
A 3x2 factorial between-subjects design was used to test the hypotheses. The independent
variables were market condition (Separating, Pooling, and Uncertain), and price (Low and High).
The stimulus product used was a fictitious new type of optical computer diskette. The
product was described as having a larger storage capacity than existing diskettes but being
compatible with existing PC disk drives. This product was chosen as a stimulus because: (1) of
subject familiarity with the product category of diskettes; and (2) conformity with the assumptions
of the price signaling game (it is a repeat purchase, experience good for which utility derived is
homogeneous across consumers, and the down-side risk of low quality is considerable (the
potential loss of data)); and (3) plausibility of an "introductory price" scenario.
4.2 Subjects and Procedure
Data consisted of responses from 161 subjects to a questionnaire administered in class.
The questionnaire was initially administered to 220 respondents. In order to ensure a rigorous test
of the economic signaling hypotheses, respondents were screened so as to meet the assumptions of
the signaling game on the basis of three questions: (1) whether they saw the diskettes as a repeat
purchase product (yes/no); (2) whether they would purchase a product at a low price, if they knew
it was of a low quality (yes/no); and (3) what they thought was the storage capacity of the
diskettes relative to those they were currently using (1=much smaller, 7=much greater). Subjects
who did not see the diskette as a repeat purchase product, who said they would purchase the
product at a low price even if they knew it to be of a low quality and/or thought this product had a
lower storage capacity than their current diskettes (<4 on the seven-point scale) were withdrawn
from analysis.
Subjects were instructed to carefully read an excerpt from an article about the new optical
diskette from a fictitious magazine called Computing Memmy Monthly. The article excerpt
5
described the new diskette, and manipulated the market conditions. It indicated a price range per
box of ten diskettes ($19 to $69)3 , and an average price per box (around $44). Market condition
was manipulated by including information about (1) the differences in the costs of production of
good and poor quality diskettes; and (2) long term prospects of the optical diskette in terms of
whether it is likely to establish itself as a standard or be overtaken by new technology before it
becomes a mass market item. The excerpts used for the three market conditions are reproduced in
Figure 1. In the Separating condition, the excerpt indicated that cost differences between
producing high and low quality diskettes were small, and that industry specialists expected the
diskette to become the new industry standard. 4 In the Pooling condition, the article indicated that
cost differences for producing high and low quality diskettes were very high (with the implication
that it would be expensive for high quality producers to signal quality through a low price). The
key manipulation information suggested that firms would not have time to benefit from repeat
business because industry specialists forecast that optical diskettes would be overtaken by new
technology before they could become mass market items. The Uncertain condition provided
subjects with no indication of differences in costs of production, and suggested uncertain future
prospects for the diskette by stating that industry specialists were divided in their forecast of the
optical diskette's future.
Subjects were then informed that they had a special offer from Typhon Tech Inc. (a
fictitious firm), to purchase a box of ten diskettes for the special introductory price of $19 or $62
(crossed with the market information condition and manipulated between subjects). They were
then asked to rate the diskettes on five quality dimensions (reliability, durability, likelihood of
malfunction, relative quality, and overall quality), and indicate their intention to purchase. All
variables were measured on seven point scales (1=low, 7=high).
6
4.3 Analysis and Results
Under the hypotheses, we expected a negative relationship between price and judgments of quality
as well as price and intentions to purchase in the Separating condition; a positive relationship in
the Pooling condition; and no relationship in the Uncertain condition. Cell means are graphically
presented in Figure 2, along with cell sizes and standard deviations.
A factor analysis of the five quality dimensions confirmed that they loaded on a single
factor which accounted for 71% of the variance. The linear combination represented by this factor
was used as the 'judgment of quality" dependent variable.
4.3.1 Effects ofPrice on Intentions to Purchase
An omnibus F-test across the three market conditions crossed with the two levels of price
reveals a significant interaction of information condition with price (F 2, 154=8.33, p<0.001)
indicating that the relationship of intentions to purchase to price differs depending on the market
condition. Planned contrasts compared cell means of intentions to purchase at the two price levels
to determine the source of the interaction. The Separating condition shows a significant negative
relationship of intentions to purchase with price (F 1, 55=4.19, p<0.05, means 4.50 vs. 3.66). In the
Pooling condition, there is a significant positive relationship of intentions to purchase with price
(F1,53=14.18, p<0.001, means 2.91 vs. 4.22). Finally, in the Uncertain condition, intentions to
purchase indicate only a marginally significant positive relationship to price (F 1,46=2.96, p<0.10,
means 3.80 vs. 4.54).
4.3.2 Effects ofPrice on Judgments of Quality
An omnibus F-test across the three market conditions crossed with the two price levels
shows that price and market condition do not interact (F2, 151
.79, >0.45). A strong main effect
of Price exists (F1,151=58.66, p<0.001) and there is no main effect of market condition (F2,
151 =3.57, p>0.55). 5 Analysis using planned contrasts compared cell means of judgments of
7
quality for the two price levels in each market condition. The results indicate a clear positive
relationship between price and judgments of quality in each of the three market conditions (F1,
54= 15.68, p<0.01 with means -0.58 vs. 0.40 in the Separating condition; F 1, 52=14.6, p<0.01 with
means -0.48 vs. 0.40 in the Pooling condition; and F 1, 45=34.61, p<0.01 with means -0.64 vs.
0.67, in the Uncertain condition).
5. Discussion and Conclusion
As predicted by the theory, the relationship of intentions to purchase with price appears to
vary depending on market condition. The specific effects are consistent with predictions from the
Nelson-Schmalensee game which suggests that in the Separating condition a negative relationship
between price and intentions to purchase should hold; in the Pooling condition, a positive
relationship; and no relationship in the Uncertain condition. However, in contrast to intentions to
purchase, consumers' judgments of quality appear to be positively related to price regardless of
market condition. This pattern of results suggests that behavioral outcomes of the market
conditions specified by the signaling game may be more complex than previous research has
shown. In particular, the two dependent variables may be affected by different aspects of the
market conditions which make up the game. However, since Economic Signaling Theory is an
"as-if' theory whose purpose is to develop equilibrium predictions, it is silent on the mechanisms
by which different behavioral outcomes may be reached. The results of the present experiment
suggest that investigating such mechanisms may be a fruitful area for future research..
An implication of these results is that behavior (intentions to purchase) may be
inconsistent with judgments of quality under certain market conditions (e.g. Separating condition).
These results support Monroe and Krishnan's (1985) conclusion that "perception of quality and
willingness to buy are separate behavioral responses." Indeed, the two responses may be subject
to different antecedents. Quality judgments may be formed on the basis of simple heuristics, using
8
price as a direct positive indicator of quality. As Lichtenstein and Burton (1989) suggest,
consumers appear to operate on the basis of a "general schema" of a positive price-quality
relationship across product categories. The results reported here suggest that the use of such
schemas may also generalize across market conditions. Intentions to purchase, on the other hand,
involve greater commitment and may be based on a more elaborate processing of available
information in the market.
A possible mechanism by which price information combines with market conditions and
leads to behavioral outcomes is suggested by previous research and argues that consumers'
response may be driven by perceptions of "fairness" of price given cost information (Kahneman,
Knetsch and Thaler 1986; Okun 1981; Urbany, Madden and Dickson 1989). Our stimuli for the
different market conditions included information on the variations in cost of production. In the
Separating condition it was stated that "Large quality differences are surprising in view of the fact
that the cost differences in the production of the high versus low quality diskettes are small and
insignificant." In this condition, .consumers may not have been willing to pay a higher price given
that it did not reflect cost differences. Subjects in the low price condition had higher intentions to
purchase than subjects in the high price condition. In the Pooling condition it was stated that
"...cost differences between producing a high quality and low quality diskette are in fact yew
high." When costs drive differences in quality, we observe a positive relationship between price
and intentions to purchase. Finally, in the Uncertain condition, there was no information about
costs and we observed no relationship between price and intentions to purchase. This explanation
for the inconsistency of judgments of quality and intentions to purchase is based on the premise
that the two dependent measures are affected by different antecedents. Understanding these
different antecedents is a promising area for future research.
9
NOTES
There need not be two firms. Consumers may be uncertain about product quality even if there were only
one firm. Assuming that lower quality is cheaper to produce and that quality is not observable, any firm
has an incentive to sell low quality products at a high price. Therefore, even a monopolist must convince
consumers that its product is of a good quality. Sending a costly signal is one means of doing so.
2 Schmalensee pointed out that consumers need to also know that the price charged by the high quality
producer is below the marginal cost of the low-quality producer. While in reality it is unlikely that
consumers have such detailed cost information, we do examine situations where consumers are given the
information and where they are not.
3 These prices were pretested to be within an acceptable price range for this product for these subjects.
4 In one sub-condition subjects were additionally given the marginal cost of producing a diskette.
s The Separating condition had been split into two sub-conditions where one set of subjects received
marginal cost information and the other set did not. The results show no interaction of sub-condition with
price on judgments of quality (F 1, 52=2.17, p0.14), and no main effect of sub-condition on judgments of
quality (F1,p>0.85). Similarly, no interaction of the sub-condition with price was observed for
intentions to purchase (F1, 53= 0.26, p>0.61) and there was no main effect of sub-condition (F1,53=0.66,
p0.42). The two sub-conditions were collapsed into a single Separating condition for further analysis.
10
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(June), 111-123.
Chu, Wujin (1993), "Deand Signalling and Screening in Channels of Distribution," Marketing Science, 11,
4, 327-347.
Kahneman, Daniel, Jack L. Knetsch and Richard Thaler (1986), "Fairness as a Constraint on Profit Seeking:
Entitlements in the Market," The American Economic Review, 76 (September), 728-741.
Kinnani, Amna (1990), "The Effect of Perceived Advertising Costs on Brand Perceptions," Journal of
Consumer Research, 17 (September), 160-171.
Kinnani, Amna and Peter Wright (1989), "Money Talks: Perceived Advertising Expense and Expected
Product Quality," Journal of Consumer Research, 16 (December), 344-353.
Lichtenstein, Donald R. and Scot Burton (1989), "The Relationship Between Perceived and Objective PriceQuality", Journal ofMarketing Research, (Nov.), 429-443.
Monroe, Kent B. and R. Krishnan (1985), "The Effect of Price on Subjective Product Evaluations," in
Perceived Quality: How Consumers View Stores and Merchandise, Jacob Jacoby and Jerry C. Olson
eds., Lexington, MA: Lexington Books, pp 209-232.
Nelson, Philip (1970), "Information and Consumer Behavior," Journal of Political Economy, 78 (2), 311329.
Nelson, Philip (1974), "Advertising as Information," Journal ofPolitical Economy, 81 (July-August), 729754.
Okun, Arthur (1981), Prices and Quantities: A Macroeconomic Analysis, Washington: The Brookings
Institution.
Schmalensee, Richard (1978), "A Model of Advertising and Product Quality," Journal ofPolitical
Economy, 86 (31), 485-503.
Tirole, Jean (1992), The Theory of Industrial Organization, Second Edition, Cambridge, MA: MIT Press.
Urbany, Joel E., Thomas J. Madden, and Peter R. Dickson (1989), "All's Not Fair in Pricing: An Initial Look
at the Dual Entitlement Principle," Marketing Letters, 1(1), December, 17-26.
11
Fi
re l
Stimulus Article Excerpt
Optical Diskettes: Convenient, But Hard to Choose the
Right One?
There has been a lot of debate about the new optical diskette recently
launched by various companies. The new diskettes resemble traditional
floppies in size and form but have 10 times the storage capacity. The
optical diskette's big advantage over compact disks is that users need no
new hardware: one can read and write on the diskette using a standard 3.5"
floppy drive available on all personal computers.
The diskette itself
contains the device that converts magnetic signals to optical ones.
A recent consumer survey revealed that there are large quality differences
among different optical diskettes currently on the market. Quality ratings of
various brands of diskettes by a panel of experts ranged between 1 and 9.5
on a ten point scale, with average quality being 4.7. Satisfied customers
say the new diskettes are "much better" than traditional ones. However,
over 94% of the buyers who claimed not to be satisfied with the diskettes
they purchased said they would never buy the same brand again.
Large quality differences are surprising in view of the fact that the
cost differences in the production of the high versus low quality are
small and insignificant.
The survey also shows that cost differences between producing a high
quality and low quality diskette are in fact very high.
Prices currently on the market show considerable variation. A box of ten
diskettes can cost anywhere between $19 and $69, with average price
around $44
Industry specialists forecast that optical diskettes will become a new
standard and expect that they will eventually replace standard
magnetic diskettes as a primary storage device.
Industry specialists forecast, however, that optical diskettes will be
overtaken by new technology before they become mass market items.
Industry specialists are divided in their forecast of the o ptical diskettes'
future. While some believe that o ptical diskettes will become a new
standard and exoect that they will eventually replace standard magnetic
diskettes as a orimary storage device, others are more pessimistic and
exoect optical diskettes will be overtaken by new technology before they
become mass market items.
Note: Text in Bold appeared in the Separating condition; Text in Italics appeared in the
Pooling condition; Underlined text appeared in the Uncertain condition. All other text
appeared in all three conditions.
12
Figure 2
Cell Means (Cell sizes; Standard Deviations) of Judgments of Quality and Intentions to Purchase
under three Market Conditions
SEPARATING
POOLING
UNCERTAIN
7
6
0.40
(32; 0.79) 5
6
0.40
(29; 0.91) 5
4.50
(28; 1.75)
•••••••••••••••••■••••••••••••■■••••••••••••••■••••••••••••■••••••
4
3.66
(29; 1.34) 3
0
2.91
n ; 1-g)-----
--- -4.22 4
(32; • 1,18.
3
....-
2
2
-0.59
(28; 0.96)
0
Low
-0.48
23; 0.91)
1
-1
PRICE
High
- Judgment of Quality; left-hand scale
Intention to Purchase; right-hand scale
0
1
-1
0
Low
PRICE
High
-1
Low
PRICE
High