Endogenous Product Design and Quality with Rationally Inattentive Consumers

Abstract

In some markets, consumers do not know the attributes of all the products that are available in the market, or the prices at which they are o¤ered. To overcome this uncertainty, consumers may gather and process information about those attributes and prices. In this paper, we examine the consequences of consumer costs of doing so on …rms'product attribute and pricing decisions. To do so, we follow the rational inattention literature in assuming that, before entering the choice situation, consumers are in contact with all products, but may have an incomplete or imprecise prior idea about their attributes and prices. Further, we also assume that consumers can, at a cost, gather and process information in a non-random fashion about any (sub)set of products, with any precision about their attributes and prices. Furthermore, we assume that products are characterized by both horizontal and vertically di¤erentiated attributes, which we address as design and quality, respectively. We …nd a number of interesting results. First, if the unit costs of gathering and processing information are homogeneous among consumers, …rms should di¤erentiate their products as those costs fall, so to relax the otherwise increasing price competition. This implies that equilibrium prices may increase as these costs decrease, because product di¤erentiation countervails the otherwise negative impact on prices. Second, if the unit costs of gathering and processing information are heterogeneous among consumers, with a sizeable proportion of "informed" consumers, …rms should always seek to di¤erentiate their products as maximum as possible, independently of the level of information costs of the "uninformed" consumers. This implies that equilibrium price levels do not increase (and, in fact, tend to decrease) as the unit costs of those consumers decrease and that "informed" consumers serve as a "market competition guardian". Finally, in all the above cases, …rms do not need to di¤erentiate themselves along all attribute dimensions. Di¤erentiation along one attribute dimension is more than enough to relax price competition. JEL Classi…cation: D43; D83; L13; L15We w o u ld like to th a n k S u sa n a C o sta e S ilva , a s w e ll a s nu m e ro u s se m in a rs p a rtic ip a nts a t U n ive rsid a d e C a tó lic a P o rtu g u e sa , fo r h e lp fu l c o m m e nts a n d su g g e stio n s. A ll re m a in in g e rro rs a re o f c o u rse o u r ow n . M a ria n a C u n h a is w ith U n ive rsid a d e C a tó lic a P o rtu g u e sa , C a tó lic a P o rto B u sin e ss S ch o o l a n d R e se a rch C e ntre in M a n a g e m e nt a n d E c o n o m ic s (C E G E ). E -m a il a d d re ss: m a c u n h a @ p o rto .u c p .p t. A ntó n io O só rio is w ith U n ive rsita t R ov ira i V irg ili, D e p a rta m e nt d 'E c o n o m ia a n d C e ntre d e R e c e rc a e n E c o n o m ia In d u stria l i E c o n o m ia P ú b lic a (C R E IP ). E -m a il a d d re ss: a nto n io .o so rio d a c o sta @ u rv .c a t. R ic a rd o R ib e iro is w ith U n ive rsid a d e C a tó li...