Monopolistic Competition when Price and Quality are not Perfectly Observable, RAND Journal of Economics
Consider the symmetric equilibrium of a monopolistically competitive industry in which manufacturers select price and quality to maximize expected profit and consumers maximize utility by conducting costly search among sellers using an optimal sequential search rule. Consumers search among sellers because (i) each consumer idiosyncratically evaluates each seller's quality and (ii) a retailing sector generates variation in the prices consumers pay. Consumers are handicapped in their search because their observations of firms' price and quality levels are noisy. An improvement in price information is represented by an increase in the precision with which consumers observe sellers' prices. Similarly, an improvement in quality information is represented by an increase in precision with which consumers observe sellers' quality levels. An improvement of either type of information may increase or decrease welfare. The perverse case in which improved price information decreases welfare occurs when price competition among firms becomes so intense relative to quality competition that firms select severely suboptimal levels of quality.