1. Slides Industrial Organization: Markets and Strategies Paul Belleflamme and Martin Peitz © Cambridge University Press 2009 Part V. Product quality and information Marketing tools for experience goods Chapter 13. Marketing tools for experience goods

2. © Cambridge University Press 2009 2 Objectives Chapter 13 - Objectives Learning objectives Chapter 13. Learning objectives Firms use warranties to assure consumers about product quality. To what extent does moral hazard on the consumer side limit the incentives to offer full warranties? Can branding convey information to consumers? How does competition affect brands as a means to transmit information? What is the role of umbrella brands in the context of asymmetric information? Learning objectives Chapter 13. Learning objectives Firms use warranties to assure consumers about product quality. To what extent does moral hazard on the consumer side limit the incentives to offer full warranties? Can branding convey information to consumers? How does competition affect brands as a means to transmit information? What is the role of umbrella brands in the context of asymmetric information?

3. © Cambridge University Press 2009 3 Warranties Means of information disclosure by the firm Individual actions by firms that go beyond warranty policies that are required by government (mandatory or minimum warranty) Idea A firm has private information about its product quality Can calculate the expected cost of adopting a particular warranty policy A generous warranty policy is less costly for the firm if its product is more reliable Firms can use warranties to signal that a product is reliable Warranties Chapter 13 – Warranties

4. Warranties as a reliability signal Product that breaks down within a given time interval with probability 1 – λ In this case, the consumer’s utility is set equal to zero Willingness-to-pay for a product that works properly is set equal to r > 0 If a consumer believes that the product breaks down with probability 1 – λ will buy the product if λr – p ≥ u 0 = 0 Production costs c Incurred cost for a product with breakdown probability 1 – λ is © Cambridge University Press 2009 4 Warranties Chapter 13 – Warranties

5. © Cambridge University Press 2009 5 Warranties as a reliability signal (cont’d) At stage 1 firm learns its type At stage 2 sets price and a warranty policy Warranty can only take the extreme forms of no or full warranty, Conditions such that none of the two types λ 1, λ 2 has an incentive to deviate, λ 1 > λ 2 λ 2 firm: deviation is not profitable at p 1 if λ 2 r – c ≥ p 1 – c/λ 2 λ 1 firm: deviation is not profitable if p 1 – c/λ 1 ≥ λ 2 r – c Incentive constraints are satisfied if Warranties Chapter 13 – Warranties Lesson: A firm may use a warranty as a signal to consumers that its product is relatively reliable.

6. Moral hazard on the firm side Firm chooses reliability of its product which represents its quality s = λ Compensation policy may fully or partially compensate consumers for a faulty product cost of producing a product of quality C(s) = γs² profit p – (1 – λ)ωr – γs² price p = λr + (1 – λ)ωr firm’s profit λr + (1 – λ)ωr – (1 – λ)ωr – γs² = λr – γs² independent of ω quality level λ * = r/(2γ) Does this solution survive under moral hazard? Without warranties or refunds the moral hazard problem cannot be solved Firm does not invest in quality makes zero profits © Cambridge University Press 2009 6 Warranties Chapter 13 – Warranties

7. Moral hazard on the firm side (cont’d) Full refund ω = 1 p * = r © Cambridge University Press 2009 7 Lesson: Warranties and return policies can provide incentives to firms to invest in product reliability when the firm’s investment decision cannot be observed by consumers. Warranties Chapter 13 – Warranties

8. Moral hazard on the consumer side So far neglected: The way a consumer uses its product may affect the probability that the product breaks down. Type of warranty or return policy may affect the way a consumer treats the product. Reliability λ affected by the firm’s quality choice s and the care with which consumers treats the product. Consumer effort e  [0,1] © Cambridge University Press 2009 8 Warranties Chapter 13 – Warranties

9. Moral hazard on the consumer side Double moral hazard λ (s,e) = s + αer + (1 – λ)ωr effort on the consumer side is costly: disutility D(e) = δe² Consumers’ effort depends negatively on the degree of compensation or the extent of the warranty. Intuition: A product with a full warranty does not give any incentive to consumers to provide effort to carefully use the product. For ω > 0, social underprovision of effort on the consumer side © Cambridge University Press 2009 9 Warranties Chapter 13 – Warranties Lesson: If the firm and consumers are subject to a moral hazard problem, the firm only provides partial compensation for a faulty product.

10. © Cambridge University Press 2009 10 Intertemporal branding and reputations Infinite horizon model Firm chooses quality in each period Consumers observe the price before purchase but not the quality, only observed after purchase utility r H – p for a product of high quality r L – p for a product of low quality discount factor δ < 1 Brand that covers an array of diverse products production costs c H > c L Assumption: r H – c H > r L – c L implies that under full information firm would set high quality in each period Branding Chapter 13 – Branding

11. © Cambridge University Press 2009 11 Intertemporal branding and reputations (cont’d) Repeated moral hazard Consumers may believe that a firm that offered low quality at some point in the past will also offer low quality in the present Such beliefs make deviations from high quality to low quality at any point in time very costly Say that a firm has the reputation for high quality if it never produced low quality in the past Consumers give a firm in the first period the benefit of the doubt Branding Chapter 13 – Branding

12. © Cambridge University Press 2009 12 Intertemporal branding and reputations (cont’d) Firm can cheat in period t and sell low quality at p = r H From t+1 onward, it will sell at r L since consumers expect low quality Short-term gain from lower production cost Long-term reputation loss Payoff-irrelevant past behaviour matters for present behaviour = bootstrap equilibria Branding Chapter 13 – Branding

13. © Cambridge University Press 2009 13 Intertemporal branding and reputations (cont’d) Even costly branding is a profitable strategy to solve the moral hazard problem Extension Mix of moral hazard and adverse selection Quality of a firm is realization of a random variable A firm may then decide to sell a product under the same name of a previously sold high-quality product or sell it under no name Firm uses its trusted brand for products of high quality Branding Chapter 13 – Branding

14. © Cambridge University Press 2009 14 Intertemporal branding and reputations (cont’d) Branding Chapter 13 – Branding Lesson: Suppose that a firm repeatedly faces the moral hazard problem whether to offer high quality. If consumers use past firm behaviour as a guide for future behaviour and, in particular, if they no longer trust firms that offered low quality in the past, the firm may always provide high quality.

15. © Cambridge University Press 2009 15 Reputation – Monopoly Setting Extension a firm faces an adverse selection and a moral hazard problem Consumers cannot perfectly distinguish between different types and actions of the firm in each period t = 0, 1, 2, … (imperfect monitoring) Firm can be of two types, apt or inapt Probability that consumers experience good outcome is equal to γ if the firm is apt and has provided effort In an equilibrium in which the apt firm always chooses effort, the frequency with which a good outcome is observed converges almost surely to γ Consumers who observe such a frequency become convinced that the firm in the market is apt A bad outcome is attributed to bad luck and a firm looses its incentive to provide effort Equilibrium in which the firm repeatedly provided effort does not exist Reputation mechanism breaks down Branding Chapter 13 – Branding

16. © Cambridge University Press 2009 16 Reputation – Competitive setting Consumers punish a firm with a bad outcome by switching Implies that a firm with a bad outcome exits from the market A fraction of inapt firms but also a fraction of apt firms exit the market Bad outcome is more likely to occur if the firm is inapt Share of apt firms that remain in the market increases over time Prices increase over time Since effort increases the expected length of stay in the market, future high prices provide incentives to an apt firm to exert effort. Branding Chapter 13 – Branding Lesson: Competition may solve a repeated moral hazard problem in situations in which, under monopoly, the reputation mechanism would break down.

17. © Cambridge University Press 2009 17 Umbrella branding Brand that covers an array of diverse products Experience good Consumers make inferences from the characteristics observed in one product to the characteristics of others A firm can thus try to link the expected quality of one product to the costumer’s experience with another product Branding Chapter 13 – Branding

18. © Cambridge University Press 2009 18 Case. Case. Virtues of the Virgin brand Virgin brand is perhaps the ultimate example of umbrella branding Span diverse industries including travel, tourism, telecommunications, media, bottled drinks, health and finance e.g. Virgin Atlantic, Virgin Books, Virgin drinks, Virgin Spa, Virgin Earth, Virgin Fuels, Virgin Games, Virgin Life care, Virgin Media, Virgin Mobile, Virgin Money and Virgin Vacations Need to store more copies of latest movies Richard Bransons, founder of Virgin: “Consumers understand that all values that apply to one product – good service, style, quality, value and fair dealing – apply to others” Case. Case. Virtues of the Virgin brand Virgin brand is perhaps the ultimate example of umbrella branding Span diverse industries including travel, tourism, telecommunications, media, bottled drinks, health and finance e.g. Virgin Atlantic, Virgin Books, Virgin drinks, Virgin Spa, Virgin Earth, Virgin Fuels, Virgin Games, Virgin Life care, Virgin Media, Virgin Mobile, Virgin Money and Virgin Vacations Need to store more copies of latest movies Richard Bransons, founder of Virgin: “Consumers understand that all values that apply to one product – good service, style, quality, value and fair dealing – apply to others” Branding Chapter 13 – Branding

19. © Cambridge University Press 2009 19 Umbrella branding (cont’d) Firm simultaneously decides about the product quality of its two products and the use of umbrella branding Umbrella branding is associated with a higher cost Product is sold to homogenous group of consumers with unit demand After the first period: positive probability that consumers will detect low quality Firm has a stronger incentive to provide high quality under umbrella branding there is a positive probability that a deviation will be punished in the second period Not just with respect to the product one has the bad experience with, but also with respect to the other Branding Chapter 13 – Branding

20. © Cambridge University Press 2009 20 Umbrella branding (cont’d) Firm chooses low quality and no umbrella branding for sufficiently high costs of quality provision and sufficiently low detection probabilities It chooses high quality and no umbrella branding for sufficiently low costs of quality provision and sufficiently high detection probabilities It chooses high quality and umbrella branding for an intermediate range of costs Umbrella branding then provides a safeguard to consumers, since a detection can me more severely punished Branding Chapter 13 – Branding Lesson: If beliefs can be correlated across products, the region of parameter constellations where high-quality provision can be supported as an equilibrium action expands. Hence, umbrella branding can mitigate the moral hazard problem.

21. © Cambridge University Press 2009 21 Review questions Chapter 13 - Review questions Review questions What is the simple logic of warranties as a quality signal? What limits the attractiveness of warranties as a signal for high-quality firms? Describe the basic moral hazard problem in the context of quality provision? How can reputation for high quality be sustained? Why may the reputation mechanism break down under monopoly? Why can the reputation mechanism be reinforced by competition? Why should consumers trust umbrella brands more than separate brands? Discuss the out-of- equilibrium behaviour of consumers. Review questions What is the simple logic of warranties as a quality signal? What limits the attractiveness of warranties as a signal for high-quality firms? Describe the basic moral hazard problem in the context of quality provision? How can reputation for high quality be sustained? Why may the reputation mechanism break down under monopoly? Why can the reputation mechanism be reinforced by competition? Why should consumers trust umbrella brands more than separate brands? Discuss the out-of- equilibrium behaviour of consumers.