Consumers often look to rival products' past performance as an indication of brand quality. Most firms also pay more attention to market shares than can be explained by short-run profit maximization. At the theoretical level, however, economists have concentrated on the informational content of prices to assess market conditions or quality, to the neglect of quantities. In Discussion Paper No. 713, Ramon Caminal and Programme Director Xavier Vives develop a theory of oligopolistic competition and consumer behaviour that focuses on market shares. In an industry with two long-lived firms and many short-lived consumers, each firm launches one variety of a new product and consumers gather information to estimate the quality differential.

First, if firms are initially ignorant of this differential and must learn like consumers, it reflects the matching between product characteristics and consumers' preferences. Prices cannot reveal any relevant information, but future consumers will interpret data on aggregate sales as a signal of higher relative quality, which will increase future demand. Each new generation of consumers will know past market shares, but not past prices, for which data are more costly to gather. Consumers cannot directly differentiate a firm that achieved a high market share by selling a very popular product from one that followed a very aggressive pricing strategy, but they can correctly conjecture the firms' pricing strategies. Firms therefore find it profitable `to invest in market share' in the first stages of competition,
so prices are initially low and tend to increase with the information revealed by market shares. Over time, consumers and firms learn the true quality differential and prices converge to those obtaining under complete information.

Second, if firms are perfectly informed about the quality differential, there may be multiple equilibria, but there will always be one equilibrium in which a higher market share reflects higher quality. Firms have better information than consumers, however, which their prices may reveal. But their incentives to influence consumers' beliefs through prices and through quantities usually have opposite effects on pricing, so no general result can be obtained for the degree of market competition in this case.

Why Do Market Shares Matter?: An Information-Based Theory
Ramon Caminal and Xavier Vives

Discussion Paper No. 713, October 1992 (AM)