Underpromise and Overdeliver? - Online Product Reviews and Firm Pricing

Abstract

This paper presents a quality signaling model with consumer reviews. Reviews reflect true quality as well as consumers’ expectations of quality, improving with the former and worsening with the latter. Expectation-based reviews give rise to a novel separating equilibrium with several interesting properties: (i) low quality types are deterred from charging high prices by disappointed consumers who may write bad reviews; (ii) high quality types are deterred from imitating low types and thus generating good reviews by low equilibrium prices set by the low types; (iii) prices charged by lowest quality types can be below marginal cost. The equilibrium price schedule is inversely related to the number of consumers who rely on product reviews. Hence higher reliance on reviews reduces prices. In contrast, more informative reviews may lead to lower as well as higher prices depending on how reviews are generated. These results extend to the duopoly model, where we show that prices are lower (higher) than under monopoly for prices above (below) marginal cost.