Sat 09 Jun 2012 03:33:39 PM PDT
Wherefore do the honest prosper? (part 2 in a series)
(See also: part 1)
The prophet Jeremiah asked,
"Wherefore doth the way of the wicked prosper? Wherefore are all they happy that deal very treacherously?"
But the question that has to be on everyone's mind after reading George Akerlof's "Market for Lemons" paper is: wherefore do the honest prosper?
Here's a recent example from "Car Talk" of a car seller who's pondering whether or not to disclose a problem. (I'm not buying a used Honda from anyone named Steve for a while.) If not revealing the problems with something you're trying to sell is the only way to compete with other sellers who are also "dealing very treacherously," how does anyone get any business done at all? Akerlof writes, "Dishonest dealings tend to drive honest dealings out of the market." How can a market even exist?
Now let's not all answer at once. Many institutions, norms, laws, and habits have popped up over thousands of years to deal with this problem.
Let's require licenses for sellers, and take away the license of anyone who sells tainted food.
Let's only buy from sellers who offer a guarantee. Or let's force all sellers to offer some kind of guarantee.
Let's protect trademark rights for sellers, to give sellers a mechanism for building reputation and repeat business.
I'm sure that everybody can think of a couple. But right now we're trying to figure out advertising. Can it help? Is advertising rational?
Davis, E., Kay, J. and Star, J. (1991), Is advertising rational?. Business Strategy Review, 2: 1–23. doi: 10.1111/j.1467-8616.1991.tb00156.x
the original is paywalled, so see what you can do. Here's the key point from the abstract: "It is not so much the claims made by advertisers that are helpful, but the fact that they are willing to spend extravagant amounts of money on a product that is informative."
That seems wasteful at first, but let's see how Davis et. al. explain it.
Buyers are ignorant about the quality of products from which they are choosing
Buyers become better informed after buying and using a product
Sellers have a good idea of product quality, and for what kinds of users the product is a good choice
Sellers have an incentive to misrepresent products.
"What is needed, therefore, is some means of extracting truthful information from producers a means of distinguishing those producers who genuinely believe their product to be of high quality from those who do not."
So what is a "screening mechanism" that will separate the sellers who believe their products to be of high quality from the deceptive sellers? The idea is to come up with some activity that is costly enough for low quality sellers that they won't do it, but still affordable for high quality sellers.
That's where advertising comes in. Besides just showing that a seller has the money to advertise (which they presumably got from customers, or from investors who thought the product was worth investing in), advertising also shows a willingness to have people try the product and, if it's any good, buy again.
"Only the producer who thinks that he will generate repeat sales will find it worth advertising."
That gives a testable prediction. If the screening role of advertising is important, then "products whose main attributes are either easily ascertained or impossible to verify will be less advertised than those whose main features are ascertainable with more difficulty, and verifiable in the medium term."
Davis et al. divide goods into four categories:
Search goods: easy to check out at the time of purchase, such as fruit or curtains.
Short-term experience goods: hard to evaluate before buying, but easy to try once, such as canned food.
Long-term experience goods: need more experience to judge the quality of an item, such as hair conditioner or batteries.
"Experience is of little value": Dishwashers and cars.
Products that fall into the category of long-term experience goods have the highest ratio of advertising to sales. Determining product quality is hard enough that the buyer can't do it at the store or bringing one purchase home, but it is possible, so the buyer can eventually check the seller's claims.
The conclusions of the paper suggest a positive role for advertising: the fact that a seller is willing to advertise is a useful piece of information for the buyer.
"Advertising enhances the buying opportunities of consumers by alerting them to products about which they know little, and by signalling to them the seriousness of intent of the producer. It is more about informing them than acting as the persuasive door to door salesman. The salesman will persuade them to buy things they don't need, but he won't do that for very long."
Everyone with me so far?
Markets tend to fall apart because of information asymmetries.
Advertising can help inform would-be buyers, since it's obviously expensive and signals the seller's intent.
The series so far...