8.1. Information, Advertising and Disclosure

1. 07.11.2011 Lecture 8 8.1. Information, Advertising and Disclosure Based on Carlton and Perloff (2000)

2. Where we are and where we head to? Revision and Preview Relax the assumption for… • Perfect Divisibility of Output… to get Equilibrium Inexistence • No Externalities… to get Market Failure • Price Taking… to get Contestable Market, Oligopoly • Free Entry and Exit… to get Monopoly (Cartel) • Homogeneous Good… to get Monopolistic Competition • Perfect Information… to get “Lemon” Market • No Transaction Costs… to get Mergers and Acquisitions Based on Carlton and Perloff (2000)

3. Limited Information • Consumers often do not know which store sells a good at the lowest price or how quality varies across brands. • The results of recent research on markets in which consumers have limited information are startling and contradict the strongest conclusions from the standard economic models based on perfect consumer information. • In markets in which consumers have limited information: • high-quality products may not be supplied • some of the desirable effects of perfect competition vanish and • firms may have an incentive to reduce consumers’ information • Providing consumers with information about product prices, attributes, or quality alters their purchasing behavior and thereby affects market structure. Based on Carlton and Perloff (2000)

4. Information, Advertising and Disclosure • This topic addresses the following five major questions: • What is the effect if consumers have limited information about product quality? • What is the effect if consumers have limited information about prices charged by stores? • If some consumers have full information and others only limited information, is the full-information equilibrium obtained? • Do firms have an incentive to disclose information about their products? • When advertising is welfare improving? Based on Carlton and Perloff (2000)

5. Why Information is Limited? • Research by psychologists, economists, marketing experts, and others reveals that consumers have imperfect knowledge of prices and qualities in the marketplaces where they shop. • There are five chief reasons for this limited knowledge: • Information varies in reliability – not all “information” is accurate. Moreover, information that was once correct may become dated and therefore inaccurate. • There is a cost to collecting information – it does not pay for consumers to collect information beyond the point where the marginal benefit equals the marginal cost of collecting it. • Consumers can remember and readily recall only a limited amount of information. • It is costly to process information, so it is often efficient to use rationally only some of the information one has (bounded rationality). • Some consumers do not have sufficient education or intelligence to process available information on all products correctly. Based on Carlton and Perloff (2000)

6. Limited Information about Quality • Consumers frequently do not know how quality varies across brands in markets for the services of professionals, processed foods, used goods, and complex mechanical or electronic products. • A market situation where one party (seller) to a transaction knows a material fact (the quality of the good) that the other (buyer) does not know is defined as asymmetric information. • Asymmetric information about quality can have either of two undesirable results: • Equilibrium may not exist, or • If equilibrium exists, resources are used inefficiently. Based on Carlton and Perloff (2000)

7. The Market for “Lemons” • The best-known study of the impact of limited information on market equilibrium is Akerlof’s (1970) classic analysis of the market for “lemons”. • Akerlof shows that, where sellers have perfect information and consumers have extremely limited information, a market may not exist, or only the lowest-quality product may be sold. • For example, in the used car market, the seller (current owner) has learned over time if the car rarely needs repair (a good car) or frequently needs repair (a “lemon”), whereas, at best, a potential buyer knows the probability of getting a good car. • If buyers cannot distinguish “lemons” from good cars, all the cars sell for the same price. Based on Carlton and Perloff (2000)

8. Bad Products Drive Out Good Products • Bad cars are overvalued and good cars are undervalued in the “lemon” market. • For example, suppose that consumers believe that half the used cars in the market are “lemons” that consumers value at $100 and the other half are good cars that they value at $200. • Consumers are risk-neutral: They are indifferent between having a dollar and having something that has 50% probability of being worth nothing and 50% probability of being worth $2. • Then, the value to a typical consumer of a randomly selected car is $150 (= 1/2x100 + 1/2x200). • That is, the buyer is willing to pay more than the value of a bad car ($150>$100) but less than the value of a good car ($150<$200) because the car might be a lemon. Based on Carlton and Perloff (2000)

9. Adverse Selection • The example could be extended to many qualities of cars, but the result is the same: the lowest-quality cars eventually drive all other cars out of the market. • The same problem also arises in markets for insurance: • The price of health insurance increases with age because older people are more likely to need health insurance. • Healthy senior citizens, however, may not find medical insurance attractive because the premiums are too high. • As a result, due to the asymmetric information, individuals can determine their own health better, only the worst risks buy the policy. • As in the used car example, there is adverse selection: As the market price tends to the average, only the worst quality is sold/bought. Based on Carlton and Perloff (2000)

10. Asymmetric Information Lowers Quality • Although not all markets with asymmetric information degenerate so that only the lowest-quality is sold, there is always inefficiency in these markets relative to a world with imperfect information: quality levels are too low (Leland, 1979) • These low-quality inefficiencies are due to an externality in which a firm does not completely capture the benefits of selling a higher-quality product. • When a seller provides a relatively high-quality product, the average quality in the market rises, so buyers are willing to pay more for all products. • As a result, the high-quality seller shares the benefits of its high-quality product with sellers of lower-quality products by raising the average price to all. • Because the price based on average quality is less than the cost of producing the higher-quality product, a firm is unwilling to produce and sell it. Based on Carlton and Perloff (2000)

11. Solving the Problem: Equal Information • The problem of bad products driving out good ones results from the asymmetry of information. • Where information is symmetric, markets are more likely to exist. • There are two types of symmetric information: Either both sides costlessly know the quality of a product, or neither knows it. • Where costs of obtaining information are relatively low, consumers obtain information and markets function smoothly. • Unfortunately, providing perfect information is often prohibitively expensive which rules out the solution of the problem by government intervention. Based on Carlton and Perloff (2000)

12. Solving the Problem: Equal Information • One possible solution to the asymmetric information problem is to require sellers to make disclosures. • Consumers also obtain information in at least five other ways: • Guarantees or Warranties: typically, high-quality guarantees are provided only if the life of a product does not depend heavily on how consumers use it. Otherwise there is a risk of moral hazard – buyers use the product carelessly relying on the seller to fix the problem under warranty. • Liability Laws: force the manufacturer to make good on defective products. However, the precise obligations of the manufacturer might be ambiguous, and as a result, the transaction costs (such as going to court) may be high. Based on Carlton and Perloff (2000)

13. Solving the Problem: Equal Information • Reputation: A store that expects repeated purchases by a consumer if it provides high-quality products has a stronger incentive not to provide defective products. In markets where items are purchased infrequently, reputations are harder to establish. • Experts: A disinterested party, an expert, may be able to provide the consumers with reliable information. Consumer groups may publish expert comparisons of different brands, as in Consumers Union’s Reports. • However, information is a public good, subscribers to consumer reports lend their copies to friends, libraries stock them, and newspapers report on its findings. As a result, Consumer Union does not engage in as much research as it otherwise would. Based on Carlton and Perloff (2000)

14. Solving the Problem: Equal Information • Standards and Certification: The government, consumer groups, industry groups, or others may provide information in the form of standards and certification. • A standard is a metric or scale for evaluating the quality of a particular product. • Certification is a report that a particular product has been found to meet or exceed a given level on a standard. • Standards and certification may be harmful if their information is degraded or misleading, or if they are used for anticompetitive purposes. • For example, many state and local governments license professionals, and only those meeting some minimal standards are allowed to practice. • Licensing has two offsetting effects: restrictions raise the average quality in the industry but raises the price consumers pay. Based on Carlton and Perloff (2000)

15. Evidence on Lemons Markets • The lemons market theory has been tested with both empirical and experimental evidence. • Empirical Evidence: One test of the lemons problem is to see if quality varies by type of seller. • Lacko (1986) tests the hypothesis that dealers or friends and relatives should provide better-quality cars than those purchased from a stranger through an ad. • The results based on Federal Trade Commission telephone survey data show that: • There is little evidence of a lemons market problem for used cars less than 8 years old, but there is evidence of the problem for cars 8 to 15 years old. • One can buy higher-quality cars from friends, relatives, or dealers than through ads. Based on Carlton and Perloff (2000)

16. Evidence on Lemons Markets • Experimental Evidence: The Federal Trade Commission sponsored an experimental study of markets where buyers have less information than sellers (Lynch et al. 1986). • The key results were: • Without brand names or advertising, virtually only lemons were sold. • Where only truthful claims were permitted, the market behaved almost perfectly efficient. High-quality products were supplied whether or not brand names were allowed. • Reputations alone were not enough to overcome the lemons problem. That is, when sellers had brand names but were not restricted to truthful claims, virtually only lemons were sold. The value of brand names in the experiment was not sufficient to establish reputation. Based on Carlton and Perloff (2000)

17. Limited Information About Price • Limited information can lead to a monopolistic price in what would otherwise be a competitive market. • For example, suppose that many stores in an area sell the same good and consumers have full information. • If one store raises its price above the level of others, then all consumers know it, so that store loses all its business. • The store faces a demand curve that is horizontal at the going market price which is the full-information competitive price, pc. • In contrast, suppose that some or all customers have limited information and do not know that other stores charge lower price. • Now, a store can raise its price without losing all its sales (Diamond 1971). • The store faces downward-sloping demand curve and has some market power. Based on Carlton and Perloff (2000)

18. The Tourist-Trap Model • A typical tourist, Lisa, arrives in a small town filled with souvenir stands. She has but a short time before her bus leaves, so she is unable to check the prices at each souvenir stand. • Lisa does not expect to return to this town again. Therefore, she wanders by one of these stands, sees some mugs, and decides to buy one. • If there are many such tourists, what prices do the stands charge for these mugs? Key assumptions: • All souvenir stands have the same costs and sell the identical product. • All consumers have identical demand functions. • A guidebook provides each consumer with the general distribution of prices but not the price each stand charges. • The tourist’s cost of going to a stand to check the price or to buy is c. Based on Carlton and Perloff (2000)

19. The Tourist-Trap Model – Fixed Number of Stands • Initially, assume that there are a fixed number of souvenir stands, n. • If Lisa goes to two souvenir stands her costs are 2c. • If she buys from the second stand at price p, her total cost is p+2c. • The least a mug will cost her is p+c, because she must visit at least one stand to buy a mug. • Does the full-price competitive equilibrium price hold when consumers have limited information? • If all other stands charge the competitive price, pc, it pays for a deviant firm to set a higher price, p*= pc + . • If Lisa walks to this stand, though she has an information that all the other stands charge pc she would not go to another stand as long as it would cost her more than the price difference between the two stands: p*< pc + c. • Is all stands charging p* an equilibrium? • No. By using the same argument it could be shown that this equilibrium could be also broken. • If there is a single-price equilibrium it can only be at the monopolistic price, pm. • Given that the number of stands n is small, there is no single-price equilibrium. Based on Carlton and Perloff (2000)

20. The Tourist-Trap Model – Search Cost • Can reducing search costs lower the equilibrium price? • Suppose the government or a private firm sells firm-specific price information. • As a result, the cost of search falls from c to c/2. • The analysis from the previous slide does not change as long as c is positive. • A deviant firm can still raise its price by  < c/2 and break any proposed single-price equilibrium at price less than pm. • Lowering search costs has no effect on the single-price equilibrium until search costs fall to zero. Then, consumers have full information, so the only possible equilibrium is at pc, which equals marginal cost. Based on Carlton and Perloff (2000)

21. The Tourist-Trap Model – Free Entry • With a small number of stands, each of which charges the monopoly price, each one may earn large profits. If there are no barriers to entry, these profits attract new stands. • As new stands enter the industry, the number of tourists going to any one souvenir stand falls, and profits fall. Entry continues until profits are driven to zero. • A monopolistically competitive equilibrium results: Price is above marginal cost, but each firm’s profits are zero. • The difference from the full-information case is that the additional entry does not necessarily lower price if consumers have limited information. • So, society can be worse off with free entry: Consumers do not gain from entry, firms earn zero profits, and social expenditure on sunk costs rise. • Under certain circumstances, reducing the number of firms may increase effective competition. • A deviant firm can still raise its price by  < c/2 and break any proposed single-price equilibrium at price less than pm. • Lowering search costs has no effect on the single-price equilibrium until search costs fall to zero. Then, consumers have full information, so the only possible equilibrium is at pc, which equals marginal cost. Based on Carlton and Perloff (2000)

22. The Tourists-and-Natives Model • Tourist-trap model raises two questions about markets in which consumers have limited information about price: • Is there a model in which a multiple-price equilibrium is possible? • If some consumers are fully informed, even though others have limited information, can there be a full-information equilibrium where price equals marginal cost? • A modification of the initial model allows for answering these questions. • Consider a market in which all firms have identical costs, but there are two types of consumers with different search costs. • Natives are fully informed and have zero search costs. • Tourists are uninformed consumers who have search costs of c. Based on Carlton and Perloff (2000)

23. The Tourists-and-Natives Model – many informed consumers • If there are many informed consumers, it does not pay for a firm to deviate by raising its price above pc. • All firms set the same price pc, and each is assumed to obtain an equal share of the consumers, so it sells qc = L/n units of output. • It does not pay for a deviant to raise its price, because it loses money. Although it receives more per sale, its sales fall to (1-)qc. • For large enough informed consumers, the deviant would make so few sales that its costs exceed its revenues. Based on Carlton and Perloff (2000)

24. The Tourists-and-Natives Model – many informed consumers $ AC pu pc Demand Quantity, q Based on Carlton and Perloff (2000)

25. The Tourists-and-Natives Model – few informed consumers • If there are relatively few informed consumers, a deviant firm can raise its price without losing many customers. • Let qa be the quality such that the average cost equals pu, AC(qa)=pu. • It pay for a firm to deviate if qu = (1-)L/n>qaor • The proposed full-information, competitive price equilibrium is broken but there cannot be an equilibrium where all firms charge pu. • A two-price equilibrium is possible but all firms must make the same profits. Based on Carlton and Perloff (2000)

26. The Tourists-and-Natives Model – many informed consumers $ AC pu pc Demand Quantity, q Based on Carlton and Perloff (2000)

27. The Tourists-and-Natives Model – Two-Price Equilibrium $ AC pu pc Quantity, q Based on Carlton and Perloff (2000)

28. Advertising • Advertising has many purposes. • An advertisement may inform consumers that a firm has a new product or the lowest price, or • it may help to differentiate the firm’s product from that of its rivals. • A firm uses advertisements to inform consumers of its product’s strengths but not its weaknesses. • Do firms have an incentive to solve lemons problem through advertising? Based on Carlton and Perloff (2000)

29. Advertising • The informational content of advertising depends on whether consumers can determine the quality of a product prior to purchase (Nolson, 1970, 1974). • If a consumer can establish a product’s quality by inspection before purchase, the product has search qualities. • If a customer must consume the product to determine its quality, it is said to have experience qualities. • Advertising provides direct information about the characteristics of products with search qualities. • In contrast, for experience goods, the most important information may be conveyed simply by the presence of the advertising. • Such advertisers hope that consumers infer the quality or reputability of a firm by the frequency of its advertising and the expense involved. Based on Carlton and Perloff (2000)

30. Informational versus Persuasive Advertising • Some economists distinguish between informational advertising, which describes a product’s objective characteristics, and persuasive advertising, which is designed to shift consumers’ tastes. • It seems reasonable that producers of search goods are more likely to use informational advertising and that experience-goods producers are more likely to use persuasive advertising. • The advertising/sales ratio for products classified as experience goods is three times greater than that for products classified as search goods. • Such empirical evidence must be viewed with caution because it is difficult to classify product as either experience or search goods or as using wither informational or persuasive advertising. • Some companies may use persuasive advertising to try to change consumers’ perceptions of their product when they cannot truthfully change their informative advertising. Based on Carlton and Perloff (2000)

31. Advertising to Solve the Lemons Problem • Similarly to guarantees or warranties, advertising may solve the lemons problem if it signals quality. • Suppose for example that a firm wants to start selling a high-quality experience good. • The firm believes that if consumers try its product, they will like and purchase it repeatedly. That is the firm’s incentive to provide high-quality goods is to induce repeat sales (Klein and Leffler 1981, Shapiro 1983, Rogerson 1986) • For simplicity assume that: • Consumers can find about a product’s quality only by trying the good. • The firm’s marginal and average variable costs of production are the same as those of firms that produce lower quality goods. • The high-quality firm’s advertising leads to repeat sales, whereas the low-quality firm’s advertising leads to sales only in the current period. • As a result, because the rewards to advertising are greater for the high-quality firm, it engages in more advertising. Based on Carlton and Perloff (2000)

32. Price Advertising Increases Welfare • Advertising that provides price information tends to lower the market price. • Truthful advertising lets consumers know where to buy at the lowest price. • Because it is costly, firms do not advertise unless the costs are at least covered by the additional revenues from an increase in demand. • If relatively low-price stores advertise their prices and attract more customers, the stores gain in size and the average price in the market falls (Smallwood and Conlisk 1979). • Butters (1977) shows that the less expensive is advertising or consumer search, the lower is the average price in a market. • Because advertising can lower price in a market it is in the interest of professional groups to ban advertising. Until Supreme Court decisions stopped them, doctors, dentists, and lawyers prevented advertising on the grounds that it was unprofessional. Based on Carlton and Perloff (2000)

33. Is Advertising Socially Desirable? • Newspaper columnists and social philosophers often argue that there is too much advertising because it induces consumers to buy goods they do not “need”. • The formal argument is that where products are differentiated, firms engage in more than the socially optimal amount of both persuasive and informative advertising. • Until recently, most economists concluded that very little could be said about the welfare effects of persuasive advertising. They reasoned that if advertising changes consumers’ tastes, then there is no fixed basis for comparing welfare before and after advertising. • Unfortunately, it is difficult to compare consumers’ pleasure before and after advertising if the scale on which the pleasure is measured has changed. • The price is higher than before, but consumers might be receiving more pleasure after trying the advertised product as well. Based on Carlton and Perloff (2000)

34. Is Advertising Socially Desirable? • In a clever but controversial article, Dixit and Norman (1978) argue that strong welfare conclusions can be drawn. They use the two natural extremes of consumers’ preadvertising and postadvertising tastes as the basis for their conclusions: • Preadvertising tastes correspond to the social commentators’ view who think that advertising is pure deception. • Postadvertising tastes refer to the assumption that advertising serves consumers’ interests as well. • Let’s examine the welfare effects of advertising on a monopoly and its customers. The key assumptions are: • Constant marginal cost of production. • Advertising is supplied at a constant cost and advertising agencies do not receive unusual profits. So, welfare analysis can ignore the advertising agencies. • Let  be the initial level of advertising that is increased to a new level ’. Based on Carlton and Perloff (2000)

35. Is Advertising Socially Desirable? $ D p’ A C p B Demand, D(Q, ’) MR(Q,) Demand, D(Q, ) MC = AC MR(Q,’) Q Q’ Quantity, Q Based on Carlton and Perloff (2000)

36. Profit-maximizing Advertising • An increase in informative or persuasive advertising expenditures from  to ’ causes an outward shift of the demand curve facing a firm from D(Q, ) to D(Q, ’). • The firm chooses its output given its advertising expenditures, by setting its marginal revenue with respect to quantity, MR(Q, ), equal to its marginal cost, MC(=AC). • The outward shift in the demand curve increases profits for two reasons: • Profits increase by area B and area C because the firm increases its sales from Q to Q’. The extra profit is (p’ – AC)(Q’ – Q). • Profits increase by area A because price rises from p to p’ on the Q units sold before the advertising. The extra profit is (p’ – p)Q. • If the extra expenditure on advertising, E = ’ - , is less than or equal to the increase in profits, A + B + C, the extra advertising pays. The lower the cost, the more advertising. • The firm maximizes profits by setting the marginal cost of advertising equal to the marginal benefit. Based on Carlton and Perloff (2000)

37. Social-Welfare Effect of Advertising • At any given price, consumers demand more output postadvertising. • If output falls, welfare definitely falls, and no further analysis is necessary. Let’s assume that the equilibrium price p’ and quantity, Q’, are higher in the postadvertising monopolistic equilibrium. • If preadvertising preferences of consumers are used as a criteria for welfare measurement, the additional consumer surplus from the extra units demanded is the area under the preadvertising demand curve between Q and Q’. • The cost of producing these extra units is the area under the marginal cost curve between Q and Q’. • Thus the net social gain from these extra units demanded, area B – E, is the difference between the extra consumer surplus and the cost of producing them less the cost of the additional advertising E. • Using the postadvertising preferences, welfare changes by B+C+D-E. However, for small amounts of advertising, C and D are very small relative to B, so there is little difference in the welfare change between the two standards. Based on Carlton and Perloff (2000)

38. Social-Welfare Effect of Advertising • The change in welfare, using either standard, approximately equals the increase in profits to the monopoly, A+B+C-E, less the extra expenditures, A, by consumers. • Since the monopoly increases advertising until the extra expenditure on advertising, E, exactly equals the marginal increase in profits net of advertising, A+B+C, the change in welfare must be negative (approximately, -A). There cannot be too little advertising. • Advertising is excessive: At the equilibrium, a small decrease in advertising increases welfare. • Dixit and Norman (1978) show that these results hold in oligopolistic and monopolistically competitive markets as well. • Fisher and McGowan (1979) explain, in general, that it is inappropriate to use just preadvertising or postadvertising set of preferences to evaluate the welfare effects. If advertisement changes preferences, the utility levels of consumers pre- and postadvertising cannot be compared. • Shapiro (1980) exlains that if advertising serves to inform consumers that a product exists rather thsn to shift tastes, there is too little advertising. Based on Carlton and Perloff (2000)

39. Advertising as a Barrier to Entry • Dixit and Norman (1978) and Grossman and Shapiro (1984) do not argue that all advertising is harmful. They just argue that some types of advertising are excessive. • Some economists, however, argue that persuasive advertising is anticompetitive and should be banned (Bain 1956, Comanor and Wilson 1974). • Advertising may cause some consumers to conclude mistakenly that physically identical brands differ – an effect called spurious product differentiation. • Advertising by firms already in an industry may make entry by new firms more difficult. A potential entrant must advertise extensively to overcome the goodwill created by an incumbent firm’s advertising. • However, if the incumbent has no advantage over a potential entrant in advertising, the advertising does not restrict entry even if the incumbent has built up goodwill through its past efforts (Schmalensee 1974). • There are almost as many empirical studies claiming that advertising is not anticompetitive as there are studies that it is. Based on Carlton and Perloff (2000)

40. Summary • There are five major results from models in which consumers have limited information about quality or prices: • If consumers have limited information about the quality of a product, either there is no market or, where the market exists, quality levels are usually lower than the levels produced if consumers have full information. • Where consumers have limited information about prices, no equilibrium may exist or, if it exists, even small firms may set prices above marginal costs. With this type of limited information, it is possible for welfare to be higher with fewer firms than with many. Based on Carlton and Perloff (2000)

41. Summary • When some consumers know the prices at all stores and others must incur search costs to determine the price at any given store, two types of equilibria are possible. • with enough informed consumers, the equilibrium price equals marginal cost. • with relatively few consumers, a two-price equilibrium is likely, where some stores charge a high price and others charge marginal cost. • With differently informed consumers, price discrimination is possible. • Lowering the search costs may not lower average prices. Based on Carlton and Perloff (2000)

42. Summary • Firms have incentive to inform consumers about the strengths of their products and to try to shift their tastes. • A firm determines the profit-maximizing amount of advertising by setting the marginal cost of advertising equal to the marginal benefit stemming from increased sales. • The welfare effects of advertising are complex and depend on the type of product and type of advertising. • When persuasive advertising changes consumers’ utility, one cannot determine if there is too much or too little advertising. Based on Carlton and Perloff (2000)