WORD-OF-MOUTH REPUTATIONS IN AUTO INSURANCE MARKETS (DIFFUSION)

A model of the diffusion of price and quality information in automobile insurance markets is developed. The mode of transmission of information among consumers is the word-of-mouth process, defined as a network of informal conversations in which no participant has a commercial interest in the outcome. Word-of-mouth may be more broadly conceived as the naturally occurring exposure that products receive through usage. Quality is stochastic, and reputations are private in this model. Consumers are assumed to have one period memories. If reputation is defined as the percentage of dissatisfied consumers of a given firm, then the best firms have the worst reputations in equilibrium. Since the better firms have larger market share in equilibrium, they have more satisfied consumers who attract away the dissatisfied consumers from the inferior firms at a rate which dominates the inferior firms' higher rate of creation of dissatisfied consumers. The presence of a single high-quality firm exerts a strong influence on the entire market, no matter how large. Although an increase in mobility leads to an increase in the equilibrium market share of the firms with below average quality, dynamic analysis indicates that an increase in mobility results in the stronger short term influence of a high quality firm. Unlike the iso-utility, or indifference curves of standard economic theory, in a model in which there are direct measures of the speed of transmission of price and quality information, the iso-demand structure is mediated by these parameters. Data are reviewed on the prices and quality levels of twenty auto insurance firms in New York State over the period 1977 to 1983, and the effective rates of transmission of price and quality of information are measured. An increase in the rate of transmission of price (quality) information leads to an increase in the elasticity of short-term demand with respect to price (quality). There is market power associated with high market share due to the fact that the consumers of such a firm receive less information about the price and quality levels of alternative firms.