Advertising is a good example of an economic signal, but there are many others. For example, a firm that develops a new product that is of high quality could face reluctance from consumers who, never having encountered the product before, are skeptical of the quality claims. A low introductory price could send a signal to consumers in much the same way as a costly advertising campaign. In fact, low introductory prices are often used in conjunction with advertising campaigns for new products. By offering a low introductory price, the message the firm is trying to send is: “We are selling this product for less than it is worth because we know that once you try it, you will like it so much we will make up our initial losses in repeat purchases.” Both advertising and low introductory prices depend on repeat purchases in order to be effective signals.
Some signals do not depend on repeat purchases. For example, a company that offers a warranty is signaling customers that their product is of high quality. Customers understand that the firm will incur costs if it has to fulfill warranty obligations, so it would be unprofitable to offer a generous warranty on low-quality products. Hence, customers and firms might use the presence, absence, or terms of warranties to overcome asymmetric information problems.
Types of Market Signals
Kirmani and Rao (2000) reviewed both theoretical and empirical literature on economic signals and the ways they overcome asymmetric information problems in different contexts. They grouped signals broadly into two groups. The first group is what they termed to be default-independent signals. These signals represent up-front costs that firms incur to show customers that providing low quality would not be in the firm’s economic interest. Advertising and low introductory prices, two examples already mentioned, are classified as default-independent signals. Other default independent signals include investments in brand equity defined broadly, coupons, and slotting allowances that manufacturers pay to retailers. With a default-independent signal, the firm incurs the signaling cost regardless of whether it ultimately provides high quality or low quality. The main feature is that buyers understand the signal to mean that it is in the firm’s interest to provide high quality. Investments in advertising, profits lost through low introductory prices, or large cash outlays for slotting allowances, can only be recovered if quality turns out to be high and repeat sales are good. Repeat sales are very important to default-independent signals. For non-durable and frequently purchased items (like food products) default-independent signals are common.
The second group of signals consists of what Kirmani and Rao (2000) classify to be default-contingent signals. These include warranties, money-back guarantees, and the like. For these types of signals, the firm makes no significant initial investment in the signal. If quality turns out to be bad, however, the firm stands to face costs associated with the signal. For example, if a warranty is used to signal quality and the firm defaults by providing low quality contrary to claim, it would face losses that come from settlement of customer warranty claims. In this case, repeat sales are irrelevant to whether the warranty is an effective signal. Hence, default-contingent signals are commonly associated with durable and infrequently purchased items. However, default-contingent signals can be important for frequently purchased products as well. One example is the use of a high selling price to signal high quality. This involves no up-front cost to the firm, but if the firm defaults and provides low quality at a high price, its ability to charge the high price in the future is jeopardized. By charging the high price, the firm is putting its future revenues at risk if it provides low quality.
An Effective Signal Requires a Seperating Equilibrium
This is a good place to introduce the notion of a separating equilibrium. A separating equilibrium is an outcome where the high-quality firms send signals and the low-quality firms do not. For a signal of any sort to work, it must be that high-quality firms find it advantageous to signal and low-quality firms find signals to be against their economic interest. When there is a separating equilibrium, the only thing customers need to do is to identify which firms are sending signals and which firms are not. Customers are informed of quality differences merely by observing which firms signal. In short, the signal becomes information about quality.
Unfortunately, there is nothing that says separating equilibriums will always result or will even be the norm. For example, most, if not all, producers of consumer products go to some extra expense in making their packaging look attractive. If both poor-quality and high-quality products come in attractive packaging, then attractive packaging cannot be an effective signal and cannot be used by customers to make quality judgments. In this case, there is not a separating equilibrium because both poor-quality and high-quality producers find it advantageous to signal.
Potential for Customer Abuse and Other Limitations of Signals
For some types of default-contingent signals, particularly warranties and money back guarantees, there is potential for customer abuse that results in both high-quality and low-quality firms being unwilling to signal. For example, if attention to maintenance is bothersome and costly, then customers with warranty protection may give less attention to such matters than customers without warranty protection. (Note that this is an example of moral hazard on part of the customer.) Also, the degree of subjectivity that constitutes acceptable quality will be important for default-contingent signals, such as warranties, to be effective. Warranties might work well with automobiles. It is likely that both the buyer and seller can reach an agreement as to whether a problem exists and would be covered under the warranty. For example, the transmission either works or it does not. For vacation packages, another infrequently purchased item, it would be much harder to determine whether the customer who wanted his money back after reporting a bad vacation experience has a legitimate complaint or is simply trying to abuse a money back guarantee.
Similarly, some default independent signals such as low introductory prices could, in some situations, be ineffective for lack of a separating equilibrium. If a high-quality firm uses a low introductory price, it is likely to attract quality-insensitive customers as well as quality-sensitive customers. When the high-quality firm stops its low price campaign and raises its price to the high-quality level, it loses its quality-insensitive customers. These customers do not much care about quality anyway and opt for lower-priced and lower-quality products once the campaign ends. The low introductory price signal depends on repeat purchases and a large proportion of quality-insensitive customers who do not provide repeat purchases raises the cost of using a low introductory price as a signal. In this case, customer heterogeneity raises the cost of a signal perhaps to the point where both high-quality and low-quality firms find it in their advantage to not signal.
