Can High Prices Ensure Product Quality When Buyers Do Not Know the Sellers' Cost?

Eric Bennett Rasmusen, Kelley School of Business, Indiana University
Timothy Perri, Department of Economics, Appalachian State University

Abstract

The Klein-Leffler (1981) model of product quality does not explain why high-quality firms would dissipate the rents they earn from quality- assuring price premia, and it relies on consumers knowing the cost functions of firms. In the present paper, consumers do not know any firm's cost of producing quality goods, so high- quality firms must engage in conspicuous spending to demonstrate they earn a profitable mark-up over cost. Complete rent dissipation occurs only when high and low cost firms have the same cost of producing low quality.