Quality Signaling Under External Information

Firms have traditionally used price and advertising to signal product quality when consumers are not initially well-informed about qualities of competing sellers. While the Internet has increased the frequency at which buyers face unknown sellers, it also provides abundant information about product qualities through online review and ratings systems, search engines, user forums, online social networks, etc. This paper examines how the availability of such external information impacts sellers' use of price and advertising as signaling instruments, and thereby how it impacts market prices, firm benefits and consumer welfare. We find that the interaction between the external information environment and the informational roles of price and advertising is rich and complex. External information alters firms' mix of signaling instruments, motivating firms to place more weight on price and less on (the more expensive instrument) advertising. The consequent impact on prices is not monotonic and depends on the informativeness of the external information and firms' mix of signaling instruments: (1) the conventional wisdom that more informative information leads to lower price and less advertising holds only when the external information is moderately informative; (2) more informative information can actually hurt consumers through higher prices (i.e., the high quality firm shifts signaling effort from advertising to price), if the informativeness of information is low; (3) Although the low-quality firm is more easily recognized when consumers are better informed, it can benefit from higher prices due to this shift in signaling. We strengthen our results by considering an alternative distribution structure in which sellers distribute via a platform or marketplace intermediary, hence face an additional marginal cost proportional to their prices. We find that this additional cost facilitates signaling, and the high-quality firm can earn a higher profit despite paying a commission to the intermediary