On Judging Quality by Price: Price Dependent Expectations, Not Price Dependent Preferences

Abstract

It has long been observed that some consumers may view product price as an indicator of product quality. The rationale for choosing price as an indicator of quality appears to be the belief that markets are essentially efficient and that the higher costs associated with higher quality must be reflected by a higher product price. Earlier authors [1;4;5;6;7; 11;14] have taken note of this phenomenon and have concluded that consumer preferences must be dependent on product price in this case. It is argued in this paper that it is rational to judge quality by price only if the consumer is uncertain about product quality. This implies that expectations are price dependent. Since the consumer rarely knows the exact quality of any product prior to its purchase, the use of quality indicators may be more prevalent than traditional theory would imply. If preferences or expectations are dependent on price, the traditional properties of demand equations may not hold. For example, demand may not be free of money illusion [5, 497]. Pollak' has observed that ... judging the quality of a product by its price is a rational strategy for an uncertain consumer.. . [7, 64]. He then proceeds to model price dependent preference behavior under certainty. In a deterministic environment, quality is known with certainty. If quality is known with certainty, then it is not rational for the consumer to use indirect quality indicators such as the price of the product. The principal thesis of this paper is that ex ante uncertainty about product quality can lead to price dependent subjective expectations rather than price dependent preferences. Hence, a change in price may cause a revision of expectations and not a shift in the consumer's preferences. In section II, I present a model of subjective expectations where product price is a prior indicator of product quality. A specific model of the revision of expectations is set forth.2 Two models of consumer behavior with uncertain product quality are contained in section III. In the first model, we assume that there is no demand for quality per se and that