Abstract

This research analyzes a firm’s investment in advertising that signals quality when consumers learn about quality not only from such advertising but also from interactions with other consumers in the form of observational learning or word of mouth. Further, word-of-mouth interactions may involve underreporting (not everyone shares experiences), positivity (positive experiences are communicated more widely than negative ones), or negativity (negative experiences are communicated more widely than positive ones). The analysis focuses on whether a firm should advertise more or less aggressively in the presence of such consumer interactions compared with their absence and offers four key insights. First, consumer interactions can amplify the signaling effect of advertising, and as a consequence, to prevent mimicking it may be optimal for a high-quality firm to become more aggressive and spend more on advertising to signal quality in the presence of such interactions than without. Second, as underreporting increases, it can be optimal to reduce advertising, sometimes significantly. Third, with increasing positivity, it can be optimal to increase advertising. Fourth, even with increasing nega-tivity, under certain conditions it may still be optimal to increase advertising rather than decrease it.