Endogenous Product Design and Quality When Consumers Have Heterogeneous Limited Attention

Abstract

In some markets, consumers do not know the attributes of all the products that are available in the market, or the prices at which they are offered. To reduce this uncertainty consumers may, at a cost, gather and process information about the attributes and prices of the different products. The uncertainty that persists at the time of purchase affects the competition in the market, via product attributes and prices. We examine the consequences of information costs on firms' product multi-attribute and pricing decisions when consumers have heterogeneous information costs and limited attention. We find that consumers that can gather and process information at approximately no cost rationally select to be attentive while consumers that must incur a cost rationally select to be inattentive. We find also that firms have an incentive to respond to lower information costs by increasing differentiation, but solely along the least-costly attribute dimension and if the proportion of attentive consumers in the market is small. This implies that, as information costs decrease, equilibrium prices may increase in some markets and decrease in others. Further, it implies also that when the cost of an attribute dimension in a market changes, there can be radical shifts in product attributes.

Keywords: Rational Inattention, Information Frictions, Product Differentiation, Pricing

JEL Classification: D43, D83, L13, L15