Customer perception and competitive quality strategy

MANAGERIAL AND DECISION ECONOMICS, VOL. 14,235-246 (1993)

Customer Perception and Competitive Quality Strategy

Abdul Ali and Sudhindra Seshadri College of Business and Management, University of Maryland, MD, U S A

The objective of this paper is to determine the optimum level of quality a firm should choose in a product/service, given the customers’ perceptions of quality and the reference standard in a competitive market. Our work on this quality selection problem differs from those of past researchers in that we model explicitly customer’s perceptions and the reference standard. We develop a game-theoretic model to obtain insights into the firms’ quality selection problem. The model results suggest that the market differentially provides rewards or penalties to firms depending upon customers’ perceptions as well as other market and product-specific parameters. We contrast our findings for an oligopolist with that for a monopolist and observe that although an oligopolist often provides a better quality product, he does not do so always; especially when perceptions are sufficiently weak and the reference standard is endogenous.

INTRODUCTION

The intense competition due to deregulation and globalization of markets has put an increasing pre- mium on quality of products in mass markets. This emphasis on quality is reflected in recent advertising. To quote just a few: ‘Quality is Job One’ (Ford Motor Co.), ‘Quality is Your Right’ (Chrysler Corp.) and ‘Putting Quality on the Road’ (General Motor Corp.). There is, however, a growing recog- nition among practitioners and research scholars that buyers are imperfectly informed about quality even when they buy a brand-name product.

In the economics literature there is a consider- able body of research on asymmetric information regarding quality. Briefly, the main question ad- dressed is: How will the informed seller react to circumstances where buyers are imperfectly informed about the quality of sellers’ products? In his classic article, Akerlof (1970) argues that there will be a reduction in average quality of goods and services traded in a market where one side of the market has less information. Akerlofs work identi- fies the adverse selection problem: the market eventually will be overrun by minimal quality items. Since Akerlofs work, economists have suggested several ways to prevent this market failure. Prominent among them are price signalling (Cooper and Ross, 1984; Wolinsky, 1983); search by consumers (Chan and Leland, 1982); or third-party intervention, such as consumer unions and inter-

mediaries, or certification (Leland, 1979). All these models relax some key assumptions present in Akerlofs work. For an integrative article on the implications of the dependence of quality on price, see Stiglitz (1987). Economists have also suggested several incentive schemes such as reputation (Shapiro, 1982; Rogerson, 1983; Allen, 1984) to prevent the quality-deterioration problem in the presence of information asymmetry.

In sum, the economists have traditionally con- sidered ways to prevent market failure due to adverse selection, and deterioration in quality due to moral hazard that exist in markets with asymmetric information on quality among buyers and sellers. Analysis allowing for distinction bewteen ‘objective’ and ‘perceived’ quality has not received much attention among economists. Farrel (1980) realizes this issue when he states that quality information typically is more costly to obtain than price information in order to reduce the problem of uncer- tainty regarding a product. We cannot rely upon advertisements since quality is a subjective characteristic and ‘false advertising’ of qualities is difficult to prove. Further, Shapiro (1982) suggests that the way choice of product quality relates to the information-gathering activities of individual customers, or the information flows in the market- place, remains an under-researched issue.

Management researchers have emphasized the difference between objective quality and perceived quality (Jacoby and Olson, 1985; Parsuraman et al.,

0 143-6570/93/030235- 12$11 .OO 0 1993 by John Wiley 8z Sons, Ltd.

236 A. ALI A N D S. SESHADRI

1986; Garvin, 1988; Zeithaml, 1988). Yet, there are very few articles in the management literature on strategic competition in product quality (excep- tions are: Moorthy, 1988; Carpenter, 1987; Tellis and Wernerfelt, 1987). Even these articles make no distinction between a product’s perceptual position and physical position.

In this paper we plan to integrate the richness of asymmetric information research in economics and objective-perceived quality dichotomy research in management to obtain insights into the quality choice problem of firms. Starting from the premises that the accuracy of customers’ perception of product quality is less than perfect (Zeithaml, 1988) and customers form perception of quality based on some ‘reference standard’ (Monroe, 1973), we investigate how these perceptual biases influence the firm’s optimal product quality decision under two scenarios: (1) an exogenous reference standard and (2) an endogenous reference standard. We also compare the impact of distorted perceptions on a monopolist’s and oligopolists’ optimal quality decisions. Among the questions that we address here are:

(1) How does the average customer’s perception affect a firm’s quality choice? Inaccurate perceptions of quality by the buyers tempt sellers not to provide high quality. Further, when the industry standard of quality is a joint function of each individual firm’s choice of quality level,

then a low-quality-producing firm may not be adequately penalized by poor sales. The questions then are

(2) Will quality chosen under imperfect information always be lower than quality under perfect information, as the economics literature suggests (see Shapiro, 1982)?

(3) What is the relationship between an industry standard of quality and each firm’s quality choice? and

(4) Does a market equilibrium for product quality always exist?

We use a game-theoretic approach to obtain insights into these questions.

The remainder of the paper is organized as follows. First, we present the assumptions of our model. We next characterize the equilibrium solu- tion. Then we derive and discuss our results. Finally, we summarize our key findings and outline suggestions for future research.

MODEL STRUCTURE

In this section we propose a game-theoretic model to obtain insights into the firm’s quality selection problem. As shown in Fig. 1, key features of our work are the explicit representation of customer perception, and the reference standard of quality.

Oligopoly

\ Monopoly

Oligopoly

Customer’s Perception

Exogenous

Reference Standard

Monopo 1 y

Oligopoly

Imprecise

Reference Standard Monopoly

Figure 1. Features of the proposed model structure.

CUSTOMER PERCEPTION AND QUALITY STRATEGY 237

The existing models implicitly assume accurate perceptions on the part of the customers and deal with objective quality in a competitive setting. In contrast to the existing models, we deal with subjective quality in both oligopoly and monopoly markets. We assume that each customer forms a perception of quality based on a reference standard and endogenously determine the reference standard of quality by making a simplifying assumption about the influence of market share on reference standard. Our model can also accommodate an exogenously fixed reference standard and accurate customer perceptions as special cases. We focus on Nash equilibrium solutions for the quality selection problem. The understanding of such equilibrium conditions will help us answer the questions at the outset of this paper. We outline the basic assumptions of our model below and notation is sum- marized here for easy reference:

qi = the ith firm’s manufactured or objective

Qi = ith firm’s average perceived quality, Q = the market’s reference quality,

Ui = the ith firm’s contribution to aggregate mar-

U = aggregate market utility, yi = sales volume in physical units for firm i, si = the ith firm’s market share, Ci=the ith firm’s cost function, N = number of competing firms, a, p, b, E, 0, and q are market parameters to be

We now turn to the assumptions that underlie

quality,

ket utility,

defined later.

our model:

Market structure: We consider two separate market scenarios. First, we assume an industry with N firms, each with a single product. We rule out coalition formation and cartel- like behavior among these N firms and consider strictly non-cooperative srategies. Second, we consider a monopolist with N products. Manufactured quality: We assume that each firm develops a product of varying quality level and that each firm makes a once-and- for-all quality choice. This may be thought of as a new product, but applies at any point when a firm makes a long-run quality choice. To focus on the issue of product quality as opposed to product variety we, like Shapiro

(1982), assume a single unobservable product characteristic (‘quality’) that all consumers value. Quality is different from variety in that every agent’s utility is monotonically increasing in quality. In variety models agents can have different preferred brands (Cooper and Ross, 1984). Like Moorthy (1988), we assume that an one-dimensional representation of quality does not restrict the number of product attributes. Each firm’s product can have any number of attributes, but without loss of generality we analyze competition on a single- product attribute. Reference standard of quality: The market’s reference standard is a function, H(. . .), of the perceived qualities of all N firms in the market. The specific functions investigated here are a constant (Q exogenous), or a weighted mean of the perceived qualities (Q endogenous). The weights are the firm’s market share.

Q=H(Qi* Q z , . . . Q N ) (1)

Perceived quality: Our conceptualization of perceived quality bears similarity to the work of Parasuraman et al. (1985) on service quality. We assume that the perceived quality of a product/service is a function of the magni- tude and direction of the gap between reference standard and objective quality. Their work, however, proposes an increased discrepancy between objective quality and perceived quality based on the difference between expected service and perceived service. We assume that a customer’s sensitivity toward quality and anchoring toward a reference level of quality will increase or decrease the discrepancy between objective quality and perceived quality.

The perceived quality of the ith firm’s product is a function, Gi,m(. .), specific to each customer of the manufactured quality and the reference quality. Here m is a parameter in a family of functions of the same form. When aggregated over customers, i.e. when we take the expected value over m, the ith firm has an average perceived quality given by Gi(. .) as follows:

Qi, m = Gi, m (q iy Q)=(qi- Q)m+ Q Q~ = Jci,,,(. -1 dFm( * 1 = (qi - Q)v + Q (2)

where v = E [m]. When h =0, Qi = Q, and customers do not distinguish quality at all on the

238 A. ALI A N D S. SESHADRI

average; when v] = 1, Qi=qi , and customers perceive accurately on the average. Customers apply a scale that contracts or expands manufactured quality differences on the average when v] < 1 or v] > 1, respectively. They pre- serve the order of objective quality in forming the perceived quality. Lichtenstein and Bur- ton (1989) support this order-preserving prop- erty of perceived quality. They hypothesize there is a positive relationship between perceived and objective price-quality relationships. We assume heterogeneous customer perceptions, since m varies between zero and infinity.

(A5) Market utility function: We assume that the market has a utility given by a compensatory utility function. Spence (1979) proposed the specific form and Karnani (1983) extensively discussed it in a marketing context:

r - IR

(3)

The above utility function implicitly assume that in order to maintain the same level of utility, customers need to consume a large quantity of a low-quality product instead of a small quantity of a high-quality one. This type of utility function has some nice features such as incorporating a diminishing impact of product quality on market share as firm size increases. For a full derivation of these features and interpretation of the various parameters used in the model, see Karnani (1983). We highlight the interpretation of the parameters here.

The parameter E ( E > 0) reflects the effect of quality on the demand structure. As E increases, so does the effect of quality on both the firm’s and total industry demand. The larger the market share of a firm however, the less the effect of quality on increasing the firm’s market share; but the greater the effect on increasing the industry demand. The above utility function provides such intuitive reason- ing. The parameter ak(@k > O ) reflects the absolute product differentiation that Firm k can have in the market. Firm k can achieve this absolute differentiation through effective use of other variables not captured in the model. A firm with higher value of ah can command

a higher price for its product, everything else being equal. The parameter cl(O<a<l) reflects the cross-elasticity aspect of product differentiation. As a decreases, so does the cross- elasticity with respect to price among the different products. Finally, the parameter e(0 < 8 < 1) denotes the aggregate or industry elasticity of price. As 8 increases, the price elasticities and cross-elasticities for all firms decrease.

(A6) Cost function: Each firm’s cost of supplying a product of quality qi is given by:

ci=ciygqp (4)

where ci is a firm-specific cost parameter, 6 captures the effect of quality qi and p measures the scale effect in production.

MODEL ANALYSIS

In order to lay out the quality choice poblem we will adopt an approach that is as general as possible. First, we will characterize the profit function for the ith firm, and establish the relationship between quality and profits. Next, we derive the equilibrium conditions for the firm’s strategic choice of quality. We do this for both decision situations: when there are many oligopolist firms and when a single monopolistic firm has multiple products. The focus of our exposition is the oligopolist, since the analysis for the monopolist is very similar.

Many Firms-Single Products

We begin by expressing the ith firm’s inverse demand function as:

dU pi=- dyi

(5)

where U = aggregate market utility,

yi = the ith firm’s sale volume.

The price that each firm will receive for its product is then determined endogenously in Eqn (5). The price consumers will pay for a firm’s product is equal to the marginal increase in the consumer’s utility. We assume a non-linear positive price-quality relationship here. The model focuses on the product quality issue abstracted from pricing, while recognizing the fact that a non-linear price-quality relationship exists.


Thus, the ith firm’s profit function is:

where xi = the ith firm’s profit,

Ci = the ith firm’s cost function.

The ith firm’s quality choice is in equilibrium if it maximizes ni when all other firms fix their own quality levels at their optimal choices. this is the familiar Nash non-cooperative equilibrium con- cept. In our model the optimal quality choice of the ith firm must satisfy:

=0, i = l , . . . , N (7)

where qi = the ith firm’s manufactured quality and all other terms are as before.

We can now substitute the functional forms for Ui and Ci discussed in the previous section in order to solve Eqn (7). Since

u= [k:l cuk 1’ I

Also uk=akykaQi, k = 1, . . . , N

where ak = coefficient of product differentiation,

Qk = the market’s perception of the kth firm’s quality.

Therefore

where

Qk = (qk - Q1rl-k Q = rl ’ q k + (1 - q) Q, and

k = 1,

qk = manufactured quality,

Q = reference quality,

q =perception parameter,

. . .

Substitution of the above functional relations in Eqn (7) readily yields the required equilibrium condition:

The key result of this analysis is the composition of the marginal revenue term. Marginal revenue here consists of two terms representing a direct and an indirect effect of improving quality. In Eqn (9) the first term is an indirect effect, since a firm’s quality improvement changes the standards by which customers judge its quality. The second term in Eqn (9) is the direct revenue change without any change in the reference standard. The indirect effect is new to the literature and drives several of the results that we obtain.

The above relationship must hold simultan- eously for all N firms for an equilibrium to exist. Together with the characterization of the endogenous quality standard, Q, given by Eqn (1) the equilibrium condition yields N + 1 equations in N + 1 unknowns (namely, the qis , i = 1, . . . , N , and Q). We can solve these non-linear equations by numer- ical techniques.

Next, we derive the corresponding first-order condition for optimality when the firm is a monopolist.

Single Firm-Many Products

We further explore the implications of the reference standard and imperfect perceptions by analyzing the monopolist’s situation. The monopolist produces the entire set of products. This situation is equivalent to saying that the firms are all subsidia- ries of a parent company. The profit-maximizing criterion then applies to the joint profits of all firms. In this case, we may readily verify the first-order condition for profit maximization, Eqn (10). Here i is the index for products instead of for firms:

dCi dqi

-- - , i = l , . . . , N (10)

In the next section we contrast the earlier oligopolistic equilibrium with the equilibrium under a monopoly. We first seek analytical insights by

240 A. ALI AND S. SESHADRI

examining important special cases and concentrate on the oligopoly case in order to keep the exposition simple. We derive but do not present the de- tails for corresponding results in very similar fashion for the monopolist.

RESULTS AND DISCUSSION

We approach the discussion from the viewpoint of incentives that customer perceptions provide to improve quality and find that the presence of a reference standard and the nature of perceptions have profound implications for the firms' quality decisions. We examine the special cases where the reference quality, Q, is (1) exogenously given or (2) endogenously determined. Next, we examine the impact of customer perceptions, as captured by q, in these two cases. We also provide examples that are approximation to the idealized cases.

Exogenous Reference Quality

In this case Q is a constant. This may occur whenever a regulatory body, such as a trade association or a government agency, sets quality standards independently of what the market offers. In this event,

aQ -=O, dqi

i = l , . . . , N

Then Eqn (9) reduces to:

i = l , . . . , N (11) The marginal revenue depends upon the percep-

tion parameter, q. When q > 1, imperfect customer perceptions reward firms that have manufactured qualities superior to the reference standard, with perceived qualities higher than manufactured qualities, and vice versa for firms that have qualities inferior to the reference standard. Therefore all firms will be better off with manufactured qualities above the reference standard. This is possible since the reference standard is exogenously set and does not arise from the quality range available. It implies that firms will seek to improve their manufactured quality until the point that they are all above the reference standard. Whether they can do this will depend upon their specific cost functions. The degree with which qualities are superior to the reference standard will vary for each firm with Eqn (1 l),

the marginal revenue-marginal cost equation. Overall, in markets where the perception parameter is high (? % l), the quality of goods rises.

If however, q 4 1, neither are inferior-quality firms penalized nor are superior-quality firms re- warded sufficiently by market perceptions. This will lead to a reverse tendency from the above and, overall, market quality should be below the perfect- ly informed market situation (q = 1). In one sense, the perception parameter serves as an incentive mechanism in the firms' choice of quality. In fact, when the customer observes manufactured quality imperfectly, this introduces the possibility of moral hazard in the quality choice problem. The perception parameter serves either to mitigate the moral hazard problem (q > 1) or to acerbate it (q < 1). As it is known in the economics literature, we can then suggest:

Perceptions determine the degree of the moral hazard problem and give3rms incentives to provide varying degrees of quality.

There are some useful normative implications of this result. In markets where rj > 1, a reference quality established by consumer associations serves to increase overall quality. An example of such a market is computer software. The perceived quality of user-friendly features such as display windows often exceeds the manufacturing inputs necessary to achieve these features. Software reviewers usually popularize such features as a reference quality in their columns. Software firms therefore have strong incentives to include user-friendly features for standard computing functions as they become feasible.

There is, however, a negative side. When the reference standard is exogenous as in Eqn (1 1) the moral hazard problem is insurmountable and the market collapses when perceptions are imprecise (v=O). This is true for credence goods such as professional services (medicalbegal service) where customers cannot discern quality even after con- suming it. This implies that it does no good for regulatory institutions to set standards of perform- ance unless the customers educate themselves on how to evaluate relative qualities among products. We sum up these arguments as:

The market degenerates for pure credence goods when the reference standard is exogenously $xed.

The fate of the generic drug market illustrates this result. Patients do not have the skills to perceive and reward quality improvements or penalize

CUSTOMER PERCEPTION AND QUALITY STRATEGY

quality fraud. Tootelian et al. (1988) reported that customers viewed brand name drugs as being more effective, having less potential for adverse effects and having greater value for the money. It is no wonder then that Conlan (1991) found in a survey that 41% of pharmacists said generic drugs are worse than their brand-name counterparts in patients' acceptance. Exogenous quality standards, once established for branded drugs, do little to encourage higher quality from the generic drug manufacturers. The reported widespread corrup- tion in the approval process for generic drugs by the Food and Drug Administration highlights this market failure (Allnut et al., 1991).

Endogenous Reference Quality

The endogenous determination of the reference standard is a more complex case. Here, the reference quality depends upon the manufactured quality choice of all firms, and this manufactured quality is only imperfectly observed by the market. The reason we do not argue that the reference standard may depend on the perceived quality is that such an argument leads to a tautology. Perceived quality is itself a function of the reference standard in our model.

The endogenous nature of the reference standard introduces a new strategic possibility: free riding. This occurs because firms could conceivably improve profits by cutting costs with lower manufactured quality, and yet not pay the full penalty in terms of perceived quality since the reference standard itself falls. In short:

Perceptions determine the degree of the free-rider problem when the reference standard is endogenous.

The manufactured quality levels offered in the market determine the reference standard, Q. Products with larger market shares should have a proportionately greater impact on the reference standard. This would follow if customers use collective experience to form a reference standard against which individual firm qualities may be measured. We can model the specific relation of the reference quality to the manufactured qualities in the market, i.e. the functional form for Eqn (2), as:

24 1

where

- si aQ Yi

aqi ZYi -=--

The degree of imprecision distinguishes two further cases.

Accurate Perceptions In this event the market, on average, perceives the manufactured quality accurately. This occurs whenever the product in question is a pure experience good for which quality has been ascertained only after using the product and when there is no systematic bias sustained in the market. Here we may substitute q = 1 and Eqn (9) reduces to:

i = l , . . . , N (13)

i.e. perceived quality is the same as manufactured quality.

In Eqn (13) customers accurately observe the manufactured quality. Therefore, there is no free- rider problem, and each firm chooses a manufactured quality that corresponds to its distinguishing parameters: the product differentiation, ai, the sales volume, yi, and the specific cost function, Ci. The result that the reference standard has no impact on the firm's quality choice when perceptions are accurate is obvious and is a nice confirmation that our model's results are intuitively correct.

The kind of situation discussed above arises in markets for search (or experience) goods, such as computer hardware (or sodas). The reference standard is relevant however, for markets where perceptions are not accurate. We discuss this next.

Imprecise Perceptions This occurs when the product in question is a pure credence good. Customers are unable to distinguish between product qualities and all seem the same. This situation will arise when q = 0. Then Eqns (9) and (12) yield

dCi -- - , i = l , . . . , N (14) dqi

since

i.e. all qualities are perceived as identical.

Qk=Q, k = l , . . . , N


In Eqn (1 4), however, the free-rider problem is extreme. All manufactured qualities are perceived as identical and equal to the reference quality. It is easy to verify that the marginal revenue curve in Eqn (14) is below the marginal revenue curve in Eqn (13), since normally, CUkS Ui and (0- 1) is negative (see model assumption A5). Therefore, the quality of products is poorer when perceptions are imprecise. The free-rider problem here is acute. The endogenous reference standard is also lower for imprecise perceptions than it is for accurate ones. Customers in markets that are difficult to evaluate suffer with lower-quality products, on average.

Tellis and Wernerfelt (1987), using a meta-analysis of the empirical studies, show that the equilibrium correlation between price and quality gener- ally increases with the level of information in the market. Their result is consistent with ours. As information increases in the market, the potential for free riding decreases and the price is more close- ly correlated with manufactured quality. This discussion indicates that it is not just rising expec- tations that lead to quality improvements: Clearer perceptions have a role. For example, environ- mental lobby groups educate customers about en- vironmental hazards of manufacturing processes. A consequence is that manufacturer’s associations voluntarily raise their standards. Recent reports that the apple growers’ association was voluntarily discouraging the use of Alar, a chemical with toxic properties, is an example of this type of quality- perception interaction via an endogenous reference standard.

Single and Multiple Firms: Some Comparisons

Let us turn to our two alternate scenarios. A firm is either an oligopolist or a monopolist.

Exogenous Reference Standard First, consider the special case where the reference standard is exogenous and a constant. From Eqns (9) and (10) the condition dQ/dqi = 0 yields:

(a) Oligopoly

The marginal revenue curve for the oligopolist lies above that for the monopolist in this case. We may readily verify this by the following argument. If product quality were the same for the oligopolist and for the monopolist, then we may write, since e< 1:

ZUk + (6- 1) Ui > xUk + (0 - 1) ZUk = ezuk The marginal revenue (left-hand sides of Eqn (15)) for the oligopolist is more than that for the monopolist. In other words, the oligopolist’s marginal revenue curve lies above that for the monopolist. Both the oligopolist and the monopolist have the same marginal cost functions. Therefore, with all else constant the strictly increasing cost function, Ci, can only yield a higher marginal cost (right-hand sides Eqn of (15)). It follows that the quality, qi, itself is higher for the oligopolist than for the monopolist in order to satisfy the equality in Eqn (15). We conclude that the oligopolist chooses a better- quality product than a monopolist does when reference standards are exogenous. This leads to:

Result # 1: Oligopolists provide better qualities than does a monopolist for corresponding products when the reference standard is exogeneously j x e d .

This result underscores the argument for anti- trust legislation in regulated markets. For example, comparable markets for airplanes that exhibit either oligopolist (commercial market) or monopolist (defense market) tendencies also display dis- tinct differences associated with quality. The defense contractors need to be continually monitored and quality assurance is reported to be more prob- lematic.

Endogenous reference standard Next, consider the case where the reference standard is endogenous and determined by the average quality available in the market. Perceptions will make a difference here, and we consider the special case of accurate perceptions first. Setting q = 1, and dQ/dqi = si in Eqns (9) and (10) we obtain:

(a) Oligopoly

(b) Monopoly (b) Monopoly

a

Since 8c 1:

The marginal revenue for the oligopolist is again more than that for the monopolist, for the same product qualities. Arguing as above, this means that the oligopolist again chooses his or her product quality to be better than that of the monopolist. Also, the endogenous reference standard is higher for oligopolistic competition than for a monopoly.

Imprecise perceptions again reverse this conclusion. Setting q = 0, and dQ/dqi = si in Eqns (9) and (10) yields:

(a) Oligopoly

(b) Monopoly

Since Ui < XU,, the oligopolist's marginal revenue is less than the monopolist's. Therefore, the quality

chosen by the oligopolist is lower than that chosen by the monopolist. Since the reference standard is endogenous, it is lower under oligopoly than for a corresponding monopoly. This leads to the following surprising result:

Result # 2: Oligopolists provide lower quality than does a monopolist for corresponding products when perceptions are su.ciently weak and the reference standard is endogenous.

This suggests, for example, that a reason why procurement programs aimed at quality improvement, such as Just-In-Time procurement, work so much better with a single supplier.

The comparisons between oligopolist and corresponding monopolist behavior is very instructive. Result # 2 is due to the advantage the oligopolist can draw from free riding. This is not an option open to the monopolist. It demonstrates that no generalization is possible on whether an oligopolist always provides superior quality than a monopolist for corresponding products. The literature has hitherto not identified this result since it has not explicitly dealt with the role of an endogenously

Table 1. Equilibrium Quality Relationships Imprecise perception

h = O ) Accurate perception

(4=1)

Q =Constant Monopoly

Endogenous reference t i Y i 1 standard Oligopoly qi =

Q=--

= z s k q k

Y k , = ['( 5)- (;r-*&Y;q; +(e- 1) aiy;q; 1 = - 8 + 1 l / la- l )x

Zy,(akc; 1 y; - B + 1)liCS - 1 ) 4j aj Cj ZakY:q;+(e- l)ajYq$

c - 1 1 - 0 l / (d- l )x a -8 l N - 8 1 . ~ ci Yi 1 y k . Q qi= r i Y i 1 Yk.Q

ZYkqt Monopoly

~ ~ , ( ~ ; l ~ , ' - B ) 1 l ( d - l ) Zyk(akck- ly;-@)l'(a-e) ZYk 41 =

qi= the ith firm's manufactured or objective quality Q= the market's reference quality yi=sales volume in physical units for Firm i ai = the ith firm's effectiveness of marketing expenditures ci=cost parameter for Firm i a = industry demand substitutability across products b= a measure of scale effect in production cost 6 =the effect of quality in production cost &=the effect of quality on the demand structure @=aggregate or industry elasticity of price


formed reference standard in customer perceptions of quality.

The Role of Market Elasticities and Coefficients

Finally, we turn to the role of the market coefficients in product quality choice. The results shown in the Table 1 are useful here. The Table displays the equilibrium quality selection strategy for firms in oligopoly and monopoly markets, given the differences in the presence of a reference standard and the nature of perceptions.

In all cases (see Table 1) the market elasticity of demand, 8, concerns only the oligopolist. The nature of the market utility function is such that the price and cross-price elasticities depend upon the market elasticity, 8 (see assumption A5 earlier). Thus, monopolists do not need to consider price and cross-price elasticities for the products when customers’ perceptions are imprecise. The intuition here is that monopolists internalize the competition between the products (a benign form of cannibalization). Therefore, they do not suffer from changes in the elasticities. If perceptions are imprecise, market elasticity has no role even for oligopolies. Fur- ther, the monopolist is then unconcerned with both product absolute differentiation, ai , and the demand substitutability across products, u. We sum this up as:

Result #3: Weak perceptions reduce the role of demand and price elasticities in quality choice. Moreover, neither product absolute diferentiation nor the industry demand substitutability across products concerns a monopolist when customers are imperceptive.

Moorthy (1988) shows that cannibalization is a concern for the monopolist when customers have accurate perceptions. This makes product differentiation an important concern for the monopolist. This is so with our model as well, and is a nice confirmation of the existing literature. As may be intuitively obvious, however, the monopolist’s concern grows weaker as perceptions grow weaker. Finally, when quality perceptions are imprecise, the monopolist is unconcerned with product differentiation.

In the next section we summarize our results and conclude the paper. We discuss the limitations of our model and suggest some directions for further research.

CONCLUSION

Summary of Main Results

We first summarize our main findings in the context of the questions posed at the outset of this paper. How do imprecise perceptions affect firms’ quality choices? Our results show that customer perceptions provide firms with incentives in the quality choice decision. The nature of the product market is important. When the perceptions are accurate and the product is a search good, the reference standard has no effective role. This situation is usually rare and most often perceptions are imprecise, and product markets display credence- good characteristics.

Will imprecise perceptions always lead to a deterioration in product quality? The answer depends upon how customers collectively form the reference standard by which they measure quality perceptions. In turn, how does the reference standard affect each product quality decision? The reference standard is exogenously formed when a regulatory agency or trade association issues a standard. Then we find that the imperfect perceptions create a moral hazard problem. The customer’s degree of imprecision in discerning quality results in provid- ing incentives for the quality choice decision. The market differentially rewards or penalizes firms. The size of these incentives (or disincentives) depends upon the reference standard as well as other market- and product-specific parameters. The reference standard, however, is endogenously determined through informal word-of-mouth processes. Then, imperfect perceptions result in a free-rider problem .

Does an equilibrium for the strategic choice of quality by the several competing firms always exist? We observe that the free-rider problem can be severe enough for the market to collapse or degen- erate. The standard by which quality is perceived is itself subject to the free-rider problem when such endogenous processes are at work.

We contrasted these findings for oligopolistic markets with the results for a monopolist who produces corresponding products. The surprising discovery is that although an oligopolist often provides a better-quality product, this is not always the case. Reference standards are usually endogenous and perceptions are imprecise with high-tech consumer goods, professional services, and a host of other business-to-business services. In this event,


a monopolist provides better quality for corresponding products than does the oligopolist. The intuition behind this result is that the free-rider problem would become acute for the oligopolist but would not exist for the monopolist. The latter would internalize all product competition.

Managerial Implications

While the theory of how customers’ perceptions affect a firm’s product quality choice is of academic interest, it is also important to marketing man- agers, since firms are increasingly relying on quality to improve profitability. A firm should take into account any distortion of customers’ perceptions of product quality and the way a reference standard of quality is established to decide what product quality the firm will like to have. In a market where customers cannot ascertain quality even after using it, a firm should use some external features such as reputation or membership of a reputed organiza- tion to signal quality to the worried customers (see Weigelt and Camerer, 1988; Shapiro, 1982; Roger- son, 1983; Allen 1984). When a customer cannot perceive quality accurately and uses collective experience of the available products in the market- place to form a reference standard against which individual firm qualities may be measured, a firm with lower manufactured quality may encourage competition. This occurs because the firm could conceivably improve profits by cutting costs with lower manufactured quality, and yet not pay the full penalty in terms of perceived quality since the reference standard itself falls.

Limitations

We should stress some limitations to our model. When it is endogenous we express the reference standard as a simple function of each product’s quality and market share. There are other factors that may deserve explicit consideration in an informal word-of-mouth process that forms the reference standard. Our model could easily incorporate these factors, More basic is the nature of the market utility function we employ. The two important features of the utility function are (I) that it is compensatory and (2) that it is an aggregated utility. We may evaluate product quality in lexicographic fashion, and thresholds for quality exist below which customers just would not buy. Moreover, the aggregate utility function buries important phe-

nomena occurring at the individual customer level. For example, customer heterogeneity cannot be explicitly modeled, and therefore normative implications for market segmentation cannot be de- rived from the model. Another limitation is that the model assumes that production volumes are ob- servable and that the market clears in equilibrium. This may hold for several firms, such as for auto- mobile manufacturers, who commonly practice ad- vance production planning. We require a different model if we assume that firms privately hold this information.

Pricing and distribution decisions are important influences on the firm’s product quality choice. In this paper we do not allow for simultaneous selection of price and quality at the firm level. For example, when customers’ perceptions are imperfect, a firm may use price to signal quality (see Stiglitz, 1987, for an integrative review on the price- quality dependence). Further, a firm’s selection of a distribution outlet may signal quality, i.e. customers may form perceptions of product quality referring to the quality of the distribution outlet. These considerations are beyond the scope of this paper, but the authors are working on these extensions of the model developed here.

Finally, the oligopoly market modeled does not address coalition and co-operation strategies open to firms. A justification is that such cartel-like behavior may be unstable, as previous research has demonstrated. Moreover, co-operative strategies are difficult to justify in competitive markets.

Future Research

We can propose two immediate extensions of the line of analysis followed in this paper. Both follow from an endogenous selection of the products offered. First, it will be interesting to investigate whether (and how) a firm can benefit by marketing more than one product in an oligopolistic market. It is likely that a strategic choice of a high- and a low-quality product with different market shares courd influence an endogenous reference standard. When perceptions are imprecise the firm may profit from such a strategy. A second line of inquiry is the comparison between oligopolistic and monopolistic markets. The monopolist may well choose not to produce all the corresponding products. He or she may seek to influence reference standards by reducing (or increasing) the set. These issues are


- . . -

ington, M A Lexington Books. evidence. Journal of Marketing 52, July, 2-i2.

indicative of the substantial scope for further research. It is clear that the analysis of customer perceptions of something as fundamentally imprecise as quality has important strategic implications.

Acknowledgements Order of authorship is alphabetical; both authors contributed equally to the project. The authors thank anonymous reviewers for their helpful comments and suggestions.

REFERENCES

G. Akerlof (1970). The market for lemons: quality uncer- tainty and the market mechanism. Quarterly Journal of Economics 84,488-500.

F. Allen (1984). Reputation and product quality. Rand Journal of Economics 15, Autumn, 31 1-27.

R. F. Allnutt, D. Fensterer, J. Molzon, R. Williams and J. D. Dingell (1991). Lessons of the generic drug scandal: four points of view. Medical Marketing and Media 26,

G. S. Carpenter (1987). Modeling competitive marketing strategies: the impact of marketing-mix relationships and industry structure. Marketing Science 6, Spring,

Y. Chan and H. Leland (1982). Prices and qualities in markets with costly information Review of Economic Studies 49, 499-516.

M. F. Conlan (1991). After the storm: has the scandal shaken your confidence? Drug Topics 135, 17 June, 4 w 4 .

R. Cooper and T. W. Ross (1984). Prices, product qualities and asymmetric information: the competitive case. Review of Economic Studies 51, 197-207.

J. Farrel(l980). A model of price and quality choice, with informed and uninformed buyers. Unpublished manu- script, Department of Economics, MIT.

D. A. Garvin (1988). Managing Quality: The Strategic and Competitive Edge, New York: The Free Press.

J. Jacoby and J. Olson (1985). Perceived Quality, Lex-

August, 58-75.

208-2 1.

A. Karnani (1983). Minimum market share. Marketing Science 2, Winter, 75-93.

H. E. Leland (1979). Quacks, lemons, and licensing: a theory of minimum quality standards. Journal of Political Economy 87, 132846.

D. R. Lichtenstein and S. Burton (1989). The relationship between perceived and objective price quality. Journal of Marketing Research 26, November, 429-43.

K. B. Monroe (1973). Buyers’ subjective perceptions of price. Journal of Marketing Research 10, February, 70-80.

K. S. Moorthy (1988). Product and price competition in a duopoly. Marketing Science 5, Summer, 141-68.

A. Parasuraman, V. A. Zeitharnl and L. L. Berry (1985). A conceptual model of service quality and its implications for future research. Journal Of Marketing 49, Fall, 41-50.

W. P. Rogerson (1983). Reputation and product quality. Bell Journal of Economics 14, 508-16.

C. Shapiro (1982). Consumer information, product quality, and seller reputation. Bell Journal of Economics 13, Spring, 20-35.

M. Spence (1979). Notes on advertising, economies of scale and entry barriers. Discussion Paper # 702, Har- vard Institute of Economic Research: Cambridge, Mass.

J. E. Stiglitz (1987). The causes and consequences of the dependence of quality on price. Journal of Economic Literature 25, 143.

G. J. Tellis and B. Wernerfelt (1987). Competitive price and quality under asymmetric information. Marketing Science 6, Summer, 240-53.

D. H. Tootelian, R. M. Gaedeke and J. Schlacter (1988). Branded versus generic prescription drugs: perceptions of risk, efficiency, safety, and value. Journal of Health Care Marketing 3, September, 2G9.

A. Wolinsky (1983). Prices as signals of product quality. Review of Economic Studies 50, 647-58.

K. Weigelt and C. Camerer (1988). Reputation and cor- porate strategy: a review of recent theory and applica- tions. Strategic Management Journal 9, September/Oc- tober, 443-54.

V. A. Zeithaml (1988). Consumer perceptions of price, quality, and value: a means-end model and svnthesis of

Documents

Customer perception and competitive quality strategy