Signaling Quality with a Money-Back Guarantee: The Role of Transaction Costs

Working Paper MS 94-01

Posted: 21 May 1998

See all articles by Sridhar Moorthy

Sridhar Moorthy

University of Toronto - Rotman School of Management

Kannan Srinivasan

Carnegie Mellon University

Date Written: Undated

Abstract

Direct marketing is witnessing explosive growth. As consumers increasingly purchase products from their homes, their ability to judge the quality of products they buy is significantly reduced. In this paper we study how money-back guarantees can signal product quality in such environments. We interpret product quality broadly to mean both the level of attributes promised as well as the firm s consistency in delivering on those promises. A key aspect of our formulation is the explicit consideration of transaction costs and alternative signals of product quality. Transaction costs are the costs the seller or buyer faces when redeeming a money-back guarantee. We show that money- back guarantees cannot work as a signal of quality without seller transaction costs. However, if these costs are very large, then there are less costly ways to signal, namely by charging a high price. We compare the signaling performance of (1) price, (2) price with uninformative advertising (+money-burning ), and (3) price with a money-back guarantee. Whereas uninformative advertising does not work at all in our model, under certain conditions a money-back guarantee is necessary to signal, and under other conditions, a money-back guarantee is a useful supplement to price.

JEL Classification: D23

Suggested Citation

Moorthy, Sridhar and Srinivasan, Kannan, Signaling Quality with a Money-Back Guarantee: The Role of Transaction Costs (Undated ). Working Paper MS 94-01. Available at SSRN: https://ssrn.com/abstract=7561

Sridhar Moorthy (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

HOME PAGE: http://www.rotman.utoronto.ca/~moorthy

Kannan Srinivasan

Carnegie Mellon University ( email )

Pittsburgh, PA 15213-3890
United States

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