Product Policy in Markets with Word-of-Mouth Communication
41 Pages Posted: 7 Jun 2013
Date Written: June 6, 2013
We investigate the equilibrium relationship between product quality and word-of-mouth communication. Specifically, we ask whether firms should optimally produce "better" products when consumers are more likely to exchange information? The critical moderating factor in our model is the nature of the communication and what its primary impact is. On one hand, we might assume that the primary impact of word of mouth is to help people to better assess the utility of products with which they are already familiar. If this is the case then our model suggests that more word of mouth should lead to higher-quality products. We demonstrate that the underlying driver of this result is that the elasticity of demand with respect to quality is increasing in the proportion of consumers who are informed about the product's quality. On the other hand, it is well known that another significant effect of word of mouth is to expand awareness of a product. In a model of informative word of mouth -- which we define as word of mouth that increases the awareness level of a product -- we show that quality may either increase or decline as word of mouth expands. The answer depends, in part, on the extent to which the expansion of WOM is one of scale alone or whether it also fundamentally changes the structure of communications. Taken together, the two models therefore suggest that the firm's optimal product-policy response to the growth in social interactions depends on both the content and the structure of the underlying conversations. In addition, our results also make clear to researchers the importance of carefully specifying the nature of the social interactions and of considering the multidimensional effects they may have.
Keywords: Word of Mouth, Product Policy, Game Theory, Social Networks
JEL Classification: C7, D21, M31
Suggested Citation: Suggested Citation