The Truth Hurts: How Customers May Lose From Honest Advertising

This paper examines the impact of competition, brand equity, and the cost of overstating quality on optimal quality and quality claims of new products. We consider two firms simultaneously introducing a new product and making one-time decisions about its quality, price, and advertised quality. Using a two period model which allows for larger weight on future period sales, we find competition often leads firms to overstate quality unless they are constrained by high legal costs imposed by regulations or third-party legal action. More interesting, when competitors are constrained to be truthful in their advertising due to legal or other costs, optimal product quality can be lower and profits can be higher.