The author of this essay agrees with the statement put forward by the question, that the growth

of the Internet reduces the scope of informational differentiation, compelling firms to invest in product differentiation. Before going to the implication with the growth of the Internet, a distinction needs to be made for two types of goods and the use of advertisement for these, as introduced by Nelson (1974). Goods can be divided into search goods and experience goods. The former’s quality can be determined by inspection (e.g. apparel and furniture); while latter’s quality can be only determined ex-post, i.e. after consuming the good. Nelson argues that the scope for informational differentiation for search goods through informational advertising is low – the main purpose of advertisement for these goods is to inform consumers of the goods’ existence and functionality. Producers of low-quality search goods cannot easily mimic high-quality goods through deceptive advertising due to the goods’ nature. Informational differentiation is much more important for experience goods. The quality of these goods cannot be determined prior to purchase, and due to ‘cheap talk’ phenomenon, producers have incentive to make exaggerated claims without credibility. In such cases informational differentiation becomes important: a higher quality producer can indirectly signal product quality by high spending in advertising, an action that is difficult to mimic by lower quality producers, due to differing values of initial purchases to the producers. The value of initial purchase is higher to the high-quality producer due to the inclusion of (discounted) value of repeat purchases that follow; low-quality producers on the other hand are not likely to have repeat customers. Advertising in this case could become an indirect provider of quality information. Because of the above-mentioned differences between search goods and experience goods, the remaining part of this essay will focus on the analysis of advertising in the goods of the latter type. Now to the implications of growth of the Internet: (1) Importance of word-of-mouth Nelson (1974) argues that word-of-mouth is likely to be more relevant for expensive durable purchases due to the general difficulty and cost in obtaining information in form of word-of-mouth. Before the use of the Internet was widespread, the effort in obtaining word-of-mouth information was justified only for high-value purchases. However, growth of the Internet, in particular the growth of blogs and social networking websites, has made word-of-mouth information easier to obtain (Consider the abundance of reviews available on the Internet even for relatively inexpensive goods such as books and films). This reduces the scope of information differentiation firms can make, as firms spending high amounts on signaling advertising may fail to convince potential buyers who have a wealth of alternative sources of information available.

analogous to ‘artificial grassroots’ advertising campaigns.Q) represents the profits (sans advertising) to firm with price P. such as newspapers and television. PQq* is the profit! maximising price when a good of actual type q is believed to be Q.L}) and perceived quality Q (where Q " {H.L) π(P.L.L) $ A $ "(PH . . PlayStation Portable. additional profit for a high-quality producer when it leads consumers to believe that it is producing a high-quality product is greater than a critical value A. an example of this is the public relations disaster Sony suffered from in 2006 after it was found out that the company had mobilised an ‘astroturfing’ campaign in promoting its handheld gaming console. product differentiation has the potential in leading to informational differentiation. Advertising Cost) ≥ 0. The Internet community does however often expose campaigns of this kind.q. In contrast.H) # "(PLH * . true quality q (where q " {H. This has made it more difficult for producers of experience goods to signal quality through advertising. For firms. who developed a formal model for Nelson (1974) discussion: A separating equilibrium exists if and only if for some (Price. the author of this essay had recently launched an advertising campaign for a university society event for £50). In the condition above. Interestingly. it is easier to win word-of-mouth endorsements with higher product differentiation and quality. advertising on sites like Google and Facebook can start as low as £0. As the (majority of) user reviews are written independent of producers.H) # "(PLL* .20 per head (as calculated by each click on an advertisement link. popular blogs that have greater potential to influence consumer decisions are especially placed under close scrutiny. Bloggers and social networking site users are generally not shy in pointing out the shortcomings or the strengths of a product. Bloggers hired by advertising agencies or producers who write favourable reviews are not unheard of. H L* "(PH * . carry a high threshold charge. and are popularly referred to as ‘astroturfing’. (2) Implications with decreasing cost of advertising Internet has also led to a decline in the cost of advertising. This can be further explained with a proposition put forward by Milgrom and Roberts (1986).H.Is word-of-mouth on the Internet reliable? Its impact on the scope of informational differentiation would be diminished if credibility of such information were in serious doubt. which means the threshold charge for a advertisement campaign can be at a fraction of what it had been on other advertising platforms (For instance. Advertising in traditional forms of media.L}). instead indirect control over informational differentiation is possible with product differentiation. ! ! ! whereas the extra profit for a low-quality producer using deceptive advertising is lower than A. Discovery of such covert campaigns carry substantial punishments.H.L. also known as ‘sponsored links’). producers have less direct control over informational differentiation with word-of-mouth’s growing importance.

796-821. This in turn lowers the effectiveness of such advertising. firms have to seek to differentiate in other ways. meaning that less well-known or smaller sellers can advertise more effectively to the intended group of target buyers. a producer could choose to advertise in media where A is high. P. References: Nelson. In traditional forms of media such as television and newspapers. Vol. 82 (4). J. P. 94 (4). which made signaling advertisement a more feasible option for high-quality producers. as it is increasingly likely that the extra profits low-quality producers enjoy with deceptive advertising exceed A. as discussed above. Milgrom. However the usage of traditional media has been in decline because of the substitution effect by the Internet. customised according to individual characteristics of Internet users). while it needs to be desirable for the producer of high-quality good.The above inequality implies that it needs to be not desirable for the producer of a low-quality good to advertise above A. This is important for both search good producers (as it becomes easier to notify potential customers about the existence of a product). One might argue that to achieve the effect of signaling. with less ‘waste’ as compared to traditional forms of media.” The Journal of Political Economy. 729-754. Both points (1) and (2). as well as experience goods producers (reducing the scope for informational differentiation). and as such. it becomes more difficult for the separating equilibrium to occur. suggest that the scope for informational differentiation is declining with the rise of the Internet. resulting in high A. “Price and Advertising Signals of Product Quality. “Advertising as Information. Advertising on platforms with high A carries a risk of large number of potential consumers failing to notice the signaling efforts of high-quality producers. namely product differentiation. Vol. (1986).e.” The Journal of Political Economy. . minimum advertising thresholds were high. The allows a separating equilibrium where the producer of high-quality good can credibly signal its quality by spending greater than A on advertising. Apart from lowering advertisement costs. such as television. (1974). As A decreases. Internet advertisements can be highly targeted (i. and Roberts.

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