Discussion Paper

No. 2017-3 | January 30, 2017
Reexamining the Schmalensee effect


The author reexamines the Schmalensee effect from a dynamic perspective. Schmalsensee’s argument suggesting that high quality can be signaled by high prices is based on the assumption that higher quality necessarily incurs higher production cost. In this paper, the author argues that firms producing high-quality products have a stronger incentive to lower the marginal cost of production cost because they can then sell larger quantities than low-quality firms can. If this dynamic effect is large enough, then the Schmalensee effect degenerates and, thus, low prices signal high quality. This result is different from the Nelson effect relying on the assumption that only the high-quality product can generate repeat purchase, because the result is valid even if low-quality products can also be purchased repeatedly. The author characterizes a separating equilibrium in which a high-quality monopolist invests more to reduce cost and, as a result, charges a lower price. Separation is possible due to a difference in quantities sold in the second period across qualities.

JEL Classification:

D82, L15


  • Downloads: 1062


Cite As

Jeong-Yoo Kim (2017). Reexamining the Schmalensee effect. Economics Discussion Papers, No 2017-3, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2017-3

Comments and Questions

Anonymous - Referee Report 1
March 06, 2017 - 09:14

see attached file

Jeong-Yoo Kim and Nathan Berg - Reply to Referee Report 1
March 21, 2017 - 09:36

1. We briefly discussed the literature on countervailing incentives and compared it with our signaling model. See the last paragraph of p.3.
2. We changed equation (4) in a more reader-friendly way as you suggested.

Anonymous - Referee Report 2
March 13, 2017 - 07:59

see attached file

Jeong-Yoo Kim and Nathan Berg - Reply to Referee Report 2
March 21, 2017 - 09:38

1. We provided some examples of cost-reducing process innovation. See the ending part of the conclusion in p.13.
2. We corrected typos. See the first and the second paragraph of p.5.
3. Thank you. We corrected the inequality.

Jeong-Yoo Kim and Nathan Berg - Revised Version
March 21, 2017 - 09:40

see attached file