The Bright Side of Cost Transparency: Facilitating Product Innovation

Abstract

A firm’s cost for its products is increasingly transparent to consumers as the firm itself or third parties publish such information. Using a dynamic model of firm pricing with forward-looking consumer choice, this paper assesses the effect of cost transparency on firm pricing, consumer surplus, firm profits and new product innovation. Cost transparency stymies the low-cost firm’s ability to intertemporally price-discriminate because consumers now correctly anticipate the future price drops and delay purchases, as it is no longer feasible to pool price with the high-cost firms, whose future prices drop less because of the high cost. Thus, cost transparency will benefit the high-cost firms but hurt the low-cost firms. Surprisingly, consumers can also be hurt by cost transparency if the firm has a high cost. However, cost transparency leads to an expected increase in both firm profits and consumer surplus—a win-win for both firms and consumers. This increase in expected firm profits facilitates greater investment by firms in new-product innovation.

Keywords: signaling, dynamic pricing, price discrimination, strategic consumer, cost transparency, consumer search, consumer surplus, market structure