Excess demand as a signal of product quality: Theory and evidence

Kwang-Sook Huh, Purdue University


Economists typically are concerned with a price that equates supply and demand, but in many cases the price is below the market-clearing level and excess demand queued. Although it is sometimes difficult to measure excess demand in real market, we can infer excess demand when we have difficulty in making reservations for well-known restaurants or best plays. ^ Specifically, it is an interesting economic puzzle that carmakers accept excess demand often during the initial periods when new cars were introduced. In face of uncertain demand, carmakers have an incentive to specify relatively a high, not low inventory level during the initial periods. The reason is that the leftover inventory conveys information about an uncertain demand function and increases the informativeness of the inventory signals for newly introduced cars. Typical studies on inventory are also emphasizing that the firm has inclination to hold a relatively high inventory when the firm is facing high uncertainty in the market. Therefore, from the view of typical inventory theory, there is no reason for carmakers to hold relatively low inventories during the initial periods when demand uncertainty is relatively high. ^ This thesis introduces a countervailing reason for an initial relatively low inventory that depends on a consumption externality among consumers. We assume that consumers make their quality inference in part on the basis of past excess demand for the good. For example, often consumers are aware of the difficulty of making reservations or queues at well-known restaurants, long waiting list to take delivery of some cars, and long lines to enter the best plays. In such cases, they infer high quality. Thus, excess demand in the previous period can influence subsequent potential buyers' purchasing behavior. It is then rational for a firm introducing a new product to adjust its initial production and price to increase the likelihood of excess demand in an attempt to influence potential consumers' perception of quality and thus subsequent demand. We formally develop a model that demonstrates this result in the context of a market with demand and quality uncertainty. The model's predictions are tested using an extensive data set of inventories and sales for new luxury and sports cars over the past 15 years. The empirical results are consistent with the theory. ^




Major Professor: John M. Barron, Purdue University.

Subject Area

Economics, General

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