Does better information lead to lower prices? Price and Advertising Signaling under External Information about Product Quality

Firms have traditionally used price and advertising to signal product quality when consumers initially are not well-informed about qualities of competing sellers. In the last two decades, the Internet has made it more feasible for buyers to connect with new sellers and products which they cannot inspect before purchase. But the Internet also provides abundant external sources of information about sellers’ product qualities, including online review and ratings systems, search engines, user forums, online social networks, expert opinions etc. This paper examines how the availability of external information to consumers impacts sellers’ use of price and advertising as signaling instruments, and thereby how it impacts market prices. We demonstrate a rich and complex interaction between the informational roles of price, advertising, and the external information environment. First, contrary to expectation, better information sometimes may have no impact at all on firms’ pricing strategy or consumer welfare. Second, when price alone is sufficient as a signaling instrument, we find that better external information about product quality acts as a substitute, hence reduces the level of price distortion (i.e., increase) needed for signaling. But, external information may alter firms’ mix of signaling instruments, motivating firms to place more weight on price and less on (the more expensive instrument) advertising. This shift causes an increase in market prices when there is an increase in the quality of external information available to buyers. Surprisingly, therefore, better information is not always a boon to buyers because it can lead to higher prices when both price and advertising are needed to signal quality. Even when external information impacts price in the expected direction (reduction), our work adds a new explanation beyond the prior understanding that search costs affect prices by changing the level of competition.