Convincing early adopters: Price signals and Information transmission

We study the optimal pricing strategy for a new product when consumers learn from both prices and early adopters’ purchase decisions. In our model, a long-lived monopolist faces a representative consumer each period. The monopolist is privately informed about his type, the probability of producing good-quality products. First-period consumers are early adopters, who learn quality before purchasing the product. Second-period consumers learn about product quality only after observing the public history, namely past price and early adopters’ purchase decisions. In this context, prices play a dual role, acting as signals of the firm’s type but also facilitating or impeding information transmission between early adopters and second-period consumers. Our main result is that separation might occur through either high or low prices (with respect to the full-information monopoly price), depending on the elasticity of demand. When demand for good-quality products is less elastic, high prices are less costly for high-type firms due to both a static (through demand) and dynamic (through information transmission) effects. On the one hand, high-type firms are marginally less affected by high prices, since they lose fewer consumers. On the other hand, early sales at higher prices carry good news about quality to second-period consumers, since such sales are more likely to come from a good than from a bad-quality product. The opposite happens occurs when demand for good-quality products is more elastic. We provide two market examples for each case and show that in the case of disruptive (incremental) innovations high (low) prices can be used as signals of quality. We finally discuss consumer welfare under the two resulting alternative equilibria, and show that the observability of early adopters’ purchase decisions improves consumer welfare when separation occurs through high prices.