Firms often use pricing to signal product quality to potential customers. That is, people assume that if a product costs more, it must therefore have a higher quality. Firms know this, take advantage of it, and price accordingly.
Now we all know, sometimes we get what we pay for and sometimes we do not. Odds are if you buy a Lexus sedan you will get a better driving experience than if you buy a Ford. Therefore, millions of us are willing to splurge on a Lexus or a BMW.
But what happens when we pay the higher price only to find the product quality does not live up to our expectations? Well, we feel cheated. Generally, these firms, or at least these particular products, don’t stay around long.
However, what happens when the consumer has limited information or knowledge about the product by which to judge the quality? And worse, even after purchase may not be perfectly able to judge the quality of the product. This can be caused by customer inexperience or transaction complexity or even hidden factors. Economists call this Asymmetric Information.
In this case, should the consumer use price as a measure of product quality?
Regardless of how you answer that question, people do it every day. That is, even without knowing a great deal about a product or service, people will still assume that higher price means higher quality.
Over the long run this is not only bad for the consumer, it is also bad for the firm. The firm will get a reputation for offering a weak value proposition.
What's more, this state can only last as long as customers, or new customers, remain uninformed. If the market or product becomes easier for the customer to understand, the firm will have to adapt to the new reality, or die.