Signaling Quality in the Presence of Observational Learning

Abstract

We study the optimal pricing strategy for a privately informed monopolist in the presence of observational learning. Early adopters learn quality before purchasing the product. Late adopters learn quality from frst-period price and early adopters’ purchase decisions. Prices generate revenues, signal quality, and determine information transmission through observational learning. Separation may occur through either high or low prices, depending on the elasticity of early adopters’ demand. When demand for good-quality products is less elastic, high prices are less costly for high-type frms due to static and dynamic efects. High-type frms are marginally less afected by high prices, since they lose fewer consumers. Moreover, early sales at higher prices carry good news about quality to late adopters. The opposite occurs when the demand for good-quality products is more elastic.