Search Costs and Risky Investment in Quality

Abstract

One striking development associated with the explosion of e-commerce is the increased transparency of sellers' quality. In this paper we analyze how this affects firms' incentives to invest in quality when the outcome of investment is uncertain. We identify two conflicting effects. On the one hand, reducing the consumer's cost of search for quality exacerbates the negative effects of delivering poor quality. On the other hand, the fact that a firm, despite its best efforts, may fail to live up to consumers' more demanding expectations, makes investment less attractive. We show that reducing the search cost leads to higher quality if the initial level of the search cost is sufficiently high but may lead to lower quality if the initial level of the search cost is sufficiently low.

Keywords: search, internet search, quality, investment in quality

JEL Classification: D83, L15