Endogenous Product Design and Quality with Rationally Inattentive Consumers
51 Pages Posted: 28 Oct 2016 Last revised: 29 Jul 2017
Date Written: July 27, 2017
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 overcome this uncertainty consumers may, at a cost, gather and process information about the attributes and prices of the different products. We present a theoretical framework that couples endogenous firms' decisions on the multi-attribute dimensions and pricing of products with endogenous consumers' decisions on what and how much information to gather and process, and which product to purchase. We find a number of interesting results. First, consumers may rationally select information strategies that do not fully eliminate their uncertainty and so, rationally select to be inattentive. Second, firms do have an incentive to respond to lower information costs by increasing differentiation, as established by the standard search literature, but solely if the proportion of "informed" consumers in the market is small and along the least-costly attribute dimension. This implies that equilibrium prices may, as the unit cost of gathering and processing information decreases, increase in some markets and decrease in others. Further, it implies also that when the cost of quality improvement 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
Suggested Citation: Suggested Citation