Competitive pricing despite search costs when lower price signals quality

Abstract

The Diamond paradox demonstrates that when learning prices is costly for consumers, each firm has market power. However, making firms privately informed about their quality and cost restores competitive pricing if quality and cost are negatively correlated. Such correlation arises from, e.g. regulation, differing equipment or skill, or economies of scale. If good quality firms have lower costs, then they can signal quality by cutting prices, in which case bad quality firms must cut prices to retain customers. This price-cutting race to the bottom ends in an equilibrium in which all firms price nearly competitively and cheap talk reveals quality.