Credence attributes and market performance

1. Credence attributes and market performance Roles for government in addressing asymmetric information problems Jane Harris Consumer Affairs Victoria, September 2009

2. A current and growing issue • Burgeoning interest in impacts of consumption and production, particularly of food, on credence attributes such as: • health (GM-free, organic, nutritional labelling) • the environment (sustainability, virtual water, food miles, carbon footprint, recyclable) • animal welfare (free range, dolphin friendly) • social welfare (locally grown, fair trade) • This is likely to continue as the economy develops • Underlying problems in markets with credence attributes have long been recognised by economists

3. Profound and pervasive problems • Nobel prizes awarded to Akerlof (‘market for lemons’) and others for recognising markets with asymmetric information do not perform ‘pretty much like other markets’. • If producers can’t signal the existence of ‘high quality’, markets collapse or don’t exist. • Credence attributes particularly vulnerable • Markets that do exist are susceptible to unscrupulous operators (‘cheating’ behaviour)

4. Signalling • To address problems due to asymmetric information, sellers use various mechanisms to signal ‘quality’ to consumers including: • warranties and guarantees; • investments in branding, advertising and sunk costs (eg shopfronts); • product standardisation, rating schemes and third-party certification; • licensing and registration schemes. • Some of these are provided by government or facilitated by government depending on potential consumer detriment and other benefit-cost considerations • There can be incentives for the private sector to try to transfer signalling costs to government

5. Regularly we hear calls for a variety of forms of government intervention • More ‘standards’; more ‘traceability’; more ‘rating’ schemes • Mandatory labelling of attributes or ‘disclosure’ • Government endorsement of privately-developed ecolabelling schemes • General calls for ‘more regulation’ • Important for government to have strong consistent messages about efficient policy instruments

6. Efficient policy instruments to address asymmetric information Efficient instruments cause minimum distortions because they directly address the ‘root causes’ of a problem: Incentive to ‘cheat’ is inversely related to the probability of detection X the penalty if caught Probability of detection can be improved (with minimum distortions) by: • Compliance and enforcement • Well-resourced and publicised enforcement of general laws such as the Fair Trading Act and proactive monitoring • Consumer knowledge • Better measurement/metric systems and information about evaluating claims Mandatory labelling (or ‘disclosure’) is NOT generally efficient unless there are other types of markets failures to consider but even then it may not be the best option

7. Other market failures? 1. Externalities • Mandatory labelling is often advocated to address environmental issues (externalities) but is rarely cost-effective because they don’t target the root cause of the problem • Indirectly targeted policy instrument cause distortions, or side effects, in other parts of the economy and they don’t successfully treat the problem • All production is subject to minimum legal requirements about the environment, animal welfare etc and many people depend on the cheapest goods possible HOWEVER • policy instruments aimed at asymmetric information will also provide confidence to those who wish to confidently purchase ecolabelled goods • policy instruments aimed at asymmetric information can be ‘held up’ to ward off calls for labelling (and other inefficient policy instruments) to address externalities

8. Food miles – an example • Definition - the transport distance between production and consumption to address environmental concerns (greenhouse gases) and regional development concerns • Not targeted at root cause of problem • Greenhouse gases are not caused by people having insufficient information about food transportation • Therefore other problems emerge • Doesn’t necessarily indicate greenhouse gases involved in production OR overall environmental impact (DOESN’T WORK) • Penalises non-locally grown products and this impacts on development which is particularly harmful for food exporting nations and developing countries • Can be a disguised attempt at protectionism against which Australia continually lobbies • Raises prices of goods to ALL consumers not just those prepared to pay premiums • Under an efficient global response (eg ETS) additional measures won’t contribute to overall reductions in greenhouse gases Others • Letter from an economist to Epicure editor • Protecting old growth forests by subsidising recycled paper

9. 2. Public goods • Health – Mandatory ‘front of pack’ nutritional labelling might be cost effective (Golan et al), by providing a consistent format (eg ‘traffic lights’) to assist consumers make healthy choices more easily • Still being researched and Australia is watching developments overseas

10. Main points • Profound and pervasive problems exist when there are credence attributes and these are increasing in importance • Vigilance is required to guard against indirect policy isntruments (which can appear attractive at first glance) and to advocate for implementation of existing efficient policy instrument • Policy instruments aimed at information asymmetries can assist in credibility of claims associated with externalities but disclosure/labelling is not generally an efficient way of achieving environmental objectives REMEMBER • It can be as important for policy officers to mount cases against bad ideas as to suggest good ones • Implementing good ideas (eg more enforcement of general laws) helps in arguing against bad ideas (eg additional industry specific regulation)

11. Further reading • Akerlof • Other NOBEL • (Golan, Kuchler and Mitchell (2000), ‘Economics of food labelling’, AER No. 793.) • Food miles and virtual water • HARRIS AND COLE (CONSUMGIN INTERESTS ETC)