Abstract
This paper examines optimal advertised quality, actual quality, and price for a firm entering a market. It develops a two-period model where advertised quality influences expectations, and hence trial and the gap between actual quality and expectations determines satisfaction, which in turn impacts second-period sales. In such situations a company makes a choice between advertising high quality and getting trial, but little repeat; and advertising low quality and getting low trial, but high repeat.
Results are derived by numerical methods, as well as analytically for a special case of the model. The model suggests it is optimal to overstate quality when (i) customers rely relatively less on advertising to form quality expectations, and (ii) customers' intrinsic satisfaction with a product is high.
These results are consistent with deceptive advertising cases at the FTC, which showed more deception for unknown firms and for firms whose customers were more satisfied. They are also consistent with the decisions made by future managers (MBAs), except that the respondents would advertise higher (versus lower) quality when advertising was effective.