Diversity and demand externalities: How cheap information can reduce welfare1

Goods and services vary along a number of dimensions independently. Customers can choose to acquire information on the quality of some dimensions and not others. Their choices affect firms’ incentives to invest in quality and so lead to indirect externalities in consumers’ choices. We illustrate these ideas in a simple model with a monopolist selling a product with two characteristics, investments in quality with stochastic realizations and heterogeneous consumers. A fall in the cost of acquiring information on the quality of one characteristic leads more consumers to verify that characteristic. Consequently, the firm may under-provide quality on the other. This may paradoxically reduce consumer surplus, profits and welfare. Our discussion concludes with a number of potential extensions and applications of the basic framework. When shopping for goods with multiple characteristics that are not easily observable, consumers’ decisions on what to observe and whether to buy affect the type of good offered and, indirectly, other consumers’ welfare. Think of a prospective student deciding on a business school. She is likely to be concerned by her expected salary on graduation and also by long-term career prospects. Business schools can tailor their programs in ways that affect these differently. Historically, students have relied on talking to alumni and on other independent research to gain relevant information. Business school guides and This paper was previously entitled “When cheap information harms consumers.” We thank a particularly helpful audience at the NY Commuters’ IO day (2005), participants at ESSET 2005, Mark Armstrong, Mariagiovanna Baccara, Alessandro Lizzeri, Volker Nocke, Laura Veldkamp and Lawrence White. Contact info: Bar-Isaac: [email protected]; Department of Economics, Stern School of Business, NYU, 44 West 4th street 7-73, NYC, NY 10012 USA; Caruana: [email protected]; Casado del Alisal 5, 28014 Madrid, Spain; and Cuñat: [email protected]; UPF, Ramon Trias Fargas 25-27, 08005 Barcelona, Spain.