Information, Consumer Choice and Firm Strategy in an Experience Good Market

Abstract

This paper models how consumers make brand choice when they have limited information. In an experience good market with frequent product entry and exit, consumers face two types of information problems: first, they have limited information about product existence; second, even if they know a product exists, they do not have full information about its quality until they purchase and consume the product. In this paper, I incorporate purchase experience and brand advertising as two sources of information, and examine how consumers utilize them in a dynamic process. Specifically, to address the awareness problem, I model the consumer choice set as a function of experience and advertising, which varies across consumers and evolves over time. In terms of quality, I allow a first-time consumer to infer product quality from advertising. Once she buys the product, she learns the quality perfectly. To better capture the dynamics, I incorporate habit formation conditional on each consumer's purchase history. The model is estimated using the AC Nielsen homescan data in Los Angeles, which records grocery shopping histories for 1,402 households over six years. Taking ready-to-eat cereal as an example, I find that consumers learn about new products quickly and form strong habits. More specifically, advertising has a significant effect informing consumers of product existence and signaling product quality. However, advertising's prestige effect is not significant. I also find that incorporating limited information about product existence leads to larger estimates of the price elasticity. Then I use instrument variables based on differentiated-products firm competition models to address the endogeneity problem of price and advertising with unobserved brand characteristics. Based on the IV estimates, I summarize the substitution pattern and simulate consumer choices under counterfactual experiments to evaluate a number of brand marketing strategies and a policy on banning children-oriented cereal advertising.