Signaling Quality through Specialization

Firms frequently position themselves as specialists. An implication of specialization is that the firm has forgone alternative opportunities. In the context of effort-intensive categories, we show that a firm can signal quality to consumers by specializing. In the model, a firm must decide to provide one service offering or to market two services. By entering a single category, the firm incurs an opportunity cost of not entering the secondary profitable category, but may attain reduced costs. The net cost is the signaling cost that a high-quality type firm incurs to signal quality over a low-quality type firm. We show that in homogenous markets, a high-quality type firm signals its high-quality type by specializing in one category. When consumers are heterogeneous, the firm can signal its high-quality type by using prices alone in both the primary and secondary categories. However, specialization can be used as a secondary signal of quality in heterogeneous markets because of lower signaling costs. We also find that signaling using specialization is more likely in the presence of competition.