1 Product Quality Signaling in Experimental Markets ROSS M. MILLER; CHARLES R. PLOTT; Econometrica; Jul 1985; 53, 4 Presented by Kelly Goldsmith 03/02/2005

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

3 Example: Super Bowl Commercials

4 Intuition:  People see ads during the Super Bowl and realize how expensive they are  Even though the ads reveal little to no information about the product, consumers view them and believe the seller is high quality  Why? The seller must be successful to afford such an ad – and to be successful many others must have purchased the good!  Implied: Others would not have purchased the good, had it not been high quality

5 Product Quality Signaling Through Pricing: Miller & Plott  Generated and manipulated experimental “markets” to explore the possibility that sellers could extract information from the buyers by becoming aware of Quality Signals

6 The Experiment: Sellers  Possessed commodities exogenously designated as “regular” or “super”  Though the grade of the commodity changed, at all times half the sellers had “regulars” and half had “supers”  Could add units of quality which would be observed (and valued) by buyers  Each unit of quality came at a cost to the seller  Adding quality to a “regular” was more costly than adding quality to a “super”  Sellers had two units to sell, so that total quantity was fixed  After the period was over the grades of the sellers’ commodities were revealed

7 The Experiment: Buyers  Received a “bonus” for purchasing at least one commodity; did not have budget restrictions  They valued “supers” over “regulars”  Had no information prior to purchase as to the grade of the commodity  Had the incentive to look for Quality Signals to help them intuit the grade of the good  All buyers had identical redemption value functions

8 The Experiment: Buyers  Redemption Value Function

9 Graph of Unit Demand and Cost:

10 Experimental Design

11 Miller & Plott Manipulations:  The authors tried a variety of manipulations: 1) The cost of adding quality to a “super” at low v. high cost to the seller 2) The bonus for purchasing one unit 3) Prices were in Francs, not dollars: the manipulated the value of a Franc 4) Degree to which the grade of the commodity (post sale) was made salient  With all these different manipulations, several models were required to explain their results

12 Theoretical Models:  The Full Information Model  The Naïve Model  The Pure Pooling Models  The Partial Pooling Model  The Most Efficient Signaling Equilibrium and Rothschild-Stiglitz  Inefficient Signaling Equilibria

13 Theoretical Predictions of Models:  Most models predict: 1) All “regulars” will sell at the same price/quality 2) All “supers” will sell at the same price/quality

14 Today’s Experiment:  Had a low cost for adding quality to a “super”  Held the bonus for purchase constant  Used dollars in stead of Francs (thus constant value)  Made the grade of the commodity (post sale) salient

15 Their Findings: Parallel Experiment - #2  Their results found that Signaling Equilibrium models apply here  Studied results as a function of Excess Value and Quality of sales

16 Discussion of Excess Value: Excess Value = X (q) = P (q) – V (R, q)  The maximum possible loss a buyer can face when purchasing a unit of quality, q  Reflects the buyer’s confidence that the unit is a “super”  It is the amount paid over the unit’s value as a “regular”

17 Experiment 2: Results  Super Mean Excess ValueMean Quality

18 Conclusions from Parallel Experiments: 1) Quality Signaling occurs when the marginal cost of signaling a “super” is relatively low Signaling Models State: The Excess Value of supers should be near $2.00 and the Excess Value of Regulars should be slightly below zero 2) Experiment 2 displayed these predicted equilibria (p=.05)

19 Which Model Best Fits the Data?  The Inefficient Signaling Equilibrium Model: Predicts super quality above 27 units Predicts super quality above 27 units  Direction of movement in Experiment #2 indicates quality levels are moving towards the most efficient signaling equilibrium

20 Conclusions:  Signaling is a real phenomenon  The notion of equilibrium is appropriate  The most efficient signaling equilibrium will emerge, if given time

21 Critique of Conclusions:  Essentially, the authors ran several very different experiments by using a variety of manipulations  As it stands, it appears they use six different models to predict results – when you have six models to chose from, one is bound to be correct!

22 Improvements on Design:  Relating to the earlier idea of “burning money”: it would have been nice to see an analysis of how sellers made all their offers rather than just an analysis of the successful transactions  Reputation Building: While the paper gives a nod to the fact that, in an experiment such as this, reputations can be built; it would be very interesting to run the experiment with anonymous sellers and see if the results were maintained

23 THANK YOU!

24 If You’re Interested in Learning More about Quality Signaling:  “Price and Advertising Signals of Product Quality” by Milgrom & Roberts (1986)  An Introduction to Game Theory (Osborne) : p. 350 – 357  The Theory of Industrial Organization (Tirole) : p