Can High Prices Ensure Product Quality When Buyers do not Know the Sellers' Cost?

TIMOTHY J. PERRI (*) I. INTRODUCTION When consumers are unaware of product quality before they buy, producers can nonetheless be punished for providing low quality by losing repeat business. Klein and Leffler (1981) demonstrate that under fairly general conditions a price with a positive profit margin is needed to induce producers to deliver the promised quality level. If the profit margin were zero, the profit would be greater from low quality than from high, even if the customers were disappointed and none of them returned. Consequently, if a firm's price equaled its cost, repeat business would be a matter of indifference. A higher price, however, increases long-run profit more for firms that provide the promised quality because such firms benefit from the repeat business of satisfied customers. At a sufficiently high price, the profit from repeat business exceeds the profit from cheating on quality. At that price, firms will provide the promised quality level. (1) Two points are of interest in the Klein-Leffler model. First, absent firm-specific capital expenditures, positive profit exists in a competitive market. Second, because consumers know the price is an incentive for high quality only if it generates sufficiently high profit, they must know the firm's production costs if a given price premium is to ensure high quality. We address both points in this article. First, although it is sometimes thought that non-price competition will dissipate profits in the Klein-Leffler model, the model does not by itself have that implication. Positive profit will indeed persist in equilibrium, even with free entry, unless some new feature is added. Second, while the Klein-Leffier model assumes producers have identical costs, though they can choose different quality levels, we will add the possibility firms differ in their marginal costs of high quality in ways buyers cannot observe. Thus, we combine moral hazard and adverse selection in a product quality model. We hope to accomplish two things: to explain how positive profits can persist in the original Klein-Leffler model and to show that adding adverse selection can result in profit dissipation. Let us explain further before setting out the model. First, profit dissipation by non-price competition lies outside the Klein-Leffler model. In that model, information is complete: buyers know only one type of firm exists, but do not know product quality when they purchase a good. (2) Thus moral hazard is possible: firms may deliver quality that is less than what they promised. A price, [P.sup.*], above average cost, [P.sub.C], is necessary to induce firms to deliver the high level of quality they promise to consumers. Entry cannot eliminate the resulting profit, since additional output will drive price below the quality-assuring level of [P.sup.*]. This is a surprising result: an industry known to earn positive profit, without collusion or conventional barriers to entry, and yet without expanded output or entry. (3) Klein and Leffler suggest that non-price competition will dissipate this profit. They realize that non-price competition cannot reduce the operating margin by driving average cost per period up closer to price, but they suggest that some kind of fixed cost might absorb the profit: Competition to dissipate the economic profits earned by existing firms must therefore occur in nonprice dimensions... The competition involves firm-specific capital expenditures. [Klein and Leffler (1981, 626)] Such thinking comes naturally to economists; we hold the maxim that "Markets abhor a profit" as dearly as physics does "Nature abhors a vacuum." Non-price competition would occur if each firm could increase profit via such behavior, even though the net effect of many firms doing it would dissipate profit. Such is the case with a cartel, where each cartel member can do better if it cheats on the collusive agreement, using secret price cuts or non-price competition that tends to drive profit to zero. …