Competitive equilibrium with quality uncertainty

Abstract

The product quality plays important role in modeling competition. This paper explains the behaviors of both consumers and firms by using Monte Carlo simulation when they face quality uncertainty during the competition. Quality uncertainty will lead to market failure, which decreases consumer welfare and distorts profits among firms. Uninformed consumers that face difficulty to recognize quality of each product are easily deceived by firms. Because consumers use price as a signal of product quality, deceiving firms set the high price with low quality (pooling price strategy) to deceive uninformed consumers. Model of simulation shows the Nash equilibrium results for three cases. In the first cases when all consumers are informed, all firms will set reasonable price with their quality (separating price strategy). The utility is the highest. In the second cases when the market has a small fraction of uninformed consumers and low deceiving power of firm, at the Nash equilibrium the lowest quality producing firm will use the pooling price strategy. The consumer utility decreases when the uninformed fraction increases. In the last case with more uninformed consumers or high power of deceiving, at the Nash equilibrium firms that produce the highest quality and the lowest quality will use the separating price strategy whereas the firms that produce medium quality products will use the pooling price strategy. The medium quality firms have incentives to create the unclear quality to consumers by using the pooling price strategy to increase profits. The utility of consumers in last two cases are not maximized because some consumers suffer from consuming low-quality products with high-priced. Consumers will adjust their taste to eliminate quality uncertainty. When no ones will be deceived, welfare of buyers is high but there are still some losses from deceiving attempt. This utility level is lower than in the case when there is no quality uncertainty. Policymakers can solve this problem by giving information about quality to buyers before they make a decision. Government should set up the regulation for the producer to reveal quality of their product in comparison with others opponents or make the consumers guide book to explain the feature of products to consumers. These measures will help eliminate the quality uncertainty to uninformed consumers and raises social welfare of market.