23.03.2016

How Advance Sales Can Signal Product Quality

YU, Man | KAPUSCINSKI, Roman | AHN, Hyun-Soo

French wine and video games may seem to have little in common, but they are both subject to advance sales – that is, being offered for sale to customers before the quality of the product is widely known. This can benefit the customer by giving them guaranteed availability at a discounted price, and it is good for the seller, too, because they can increase their total sales and profits. New research suggests there may be yet another benefit: the very act of selling in advance can signal the quality of the product.

The researchers, Man Yu, Hyun-Soo Ahn and Roman Kapuscinski, had observed that sellers of certain goods or services placed only a small portion of their product up for advance sale, such as bottlers of fine wines before the production process was completed and organisers of music festivals before the line-up was announced. What was driving this decision?

To find an answer, they developed a model comparing a high-quality seller and a low-quality seller and showed that a key reason why high-sellers limit their advance-sales is information asymmetry.

When the seller knows more than the customer, such as wine sellers knowing the growing conditions and other factors affecting the quality of that season’s grapes, the customer may be hesitant to buy. Rationing capacity in advance sales can help to signal that all is good.

“Consumer uncertainty about product quality always worsens the profit of a seller offering a high-quality product since his product cannot be fully appreciated during advance sales. Pricing alone cannot be a signal for quality as the low-quality seller can easily mimic the high-quality seller. So in order to differentiate himself from the low-quality seller, the high-quality seller sacrifices some profit by reducing its capacity ration during advance sales from the level that the same seller would choose when the quality was known to the consumers.

“The customers, upon observing that only a small portion of the total capacity is offered in advance, will infer that the seller is very confident about his quality and has reserved a lot to sell in the spot period [after the product quality is known].

“In contrast, a large ration in advance will be associated with low quality, as the low-type seller expects a weak spot market and has a strong incentive to sell a lot in advance. So, as the quality difference increases, the high-type seller will reserve more capacity to sell in the spot market.”

Using only price to signal quality in advance sales would complicate things. If the seller of the high-quality product decided to increase the advance price over the spot price, this would simply discourage consumers from buying in advance. Therefore, rationing capacity is the better approach. (The authors also show it can be beneficial when the customer is fully informed about the quality, meaning there is no information asymmetry.)

However, there are a couple of circumstances in which it may not be optimal to ration capacity in advance sales. If the total capacity is very tight, both types of sellers are better off selling at spot with the high-quality sellers charging a very high spot price. And, conversely, if the seller has a large capacity and would like to sell to all potential customers, they can sell it in spot and set the price very low.

The authors also describe a circumstance when it may be better for high-quality sellers to “pool” with low-quality sellers, meaning they both follow the same strategy regarding advance sales – either both sell in advance with the same price and ration, or both neither sells in advance. This can work when customers are already optimistic about the product’s high quality and the seller’s capacity is not too tight.

Overall, the authors add, “We show that a seller can use capacity rationing in advance sales, in conjunction with the corresponding prices, to convey information about the product quality.”

YU, Man

Associate Professor
Information Systems, Business Statistics & Operations Management