A Signaling Theory of Limited Supply

This paper analyzes the role of seller-induced shortage as a signal of quality. Unlike dissipative advertising, the cost of inducing shortage is different for different quality types. It is shown that under certain conditions, a high-quality monopoly firm that signals quality by inducing shortage makes more profit than using price alone or combined with dissipative advertising. This is because the forgone profit from the lost sales is always lower for the high-quality firm than for the lowquality firm. The result explains why high-quality firms may prefer to initially limit supply with a price weakly lower than that in the complete-information case.