Information Asymmetry & Advertising

• Lecture 6 covers information asymmetry and advertising

Information Asymmetry

• Adverse selection and market signals are components of information asymmetry

Market for Used Cars

• Akerlof’s model explains the used car market dynamic
• "Stallions" represent high-quality cars valued at $10,000, while "lemons" are low-quality cars valued at $5,000
• Information asymmetry between buyers and sellers; buyers only know that the odds are 50-50 that a car is high quality (50k+50k pcs)
• Buyers adjust expectations downwards as they perceive that the average quality of cars available is 25:75%
• This shift in perceived demand leads to lower prices and eventually "lemons" drive "stallions" out of the market

Adverse Selection

• Products of varying qualities are sold at a uniform price because buyers and sellers have asymmetric information
• This leads to an overabundance of low-quality products and a scarcity of high-quality products being sold
• Insurance and credit markets are impacted by adverse selection

Importance of Reputation and Standardization

• Retail stores build reputation from their policy, and from refunds and repairs of defective products
• Dealers build reputation from dealing with authentic items, such as rare stamps, coins, books, and paintings
• Roofers, plumbers, and electricians' work is checked for quality of work, as well as restaurants for fresh ingredients
• Possible solutions: build reputation, apply standardization, and create profiling for insurance companies and banks

Market Signals

• Sellers provide information about a product's quality through signals, such as Spence
• Labour market signalling shows asymmetric information when hiring new workforce
• Significant risks for the employer: training costs and, costs of firing
• Employers are not initially aware of working attributes like diligence, skills, accuracy, and responsibility
• Education level signals the employee can send
• Higher education is more accessible to more productive candidates

Hiring Model - CBA

• Two types of labor exist; MPL₁=1 and MPL2=2, and are distributed 50-50% in the population
• Product value totals $10,000
• Average employee productivity is 1.5 over 10 years of work and revenue, where TR1= $100,000 and TR2= $200,000
• Firms pay the average productivity for annual wage: $15,000
• If firms could identify people by their productivity, they would offer them a wage equal to their marginal revenue product
• Education index (y) represents years of higher education
• Cost of education is greater for the low-productivity group, compared to the high-productivity group
  • C₁(y) = 40,000 $ ・ y
  • C2(y) = 20,000 $ ・ y
• Education has value only as a signal
• Determines education equilibrium (y*) - companies may offer $20k or $10k
• B(y) – the benefit of education, increasing wage to level and year of education

Advertisement

• Producers communicate information to consumers through various channels
  • Direct mail, promotions, telemarketing, sponsorship, and exhibitions
• Consumers are persuaded to choose a particular product or service, based on
  • Genuine differences between brands
  • Building a long-term attractive image
• 1880's saw large-scale marketing of mass-produced and standardised products, treating consumer groups homogenously
• 1950's audiences could be segmented according to key demographic and socio-economic categories through commercial radio and TV
• 1990's saw tendency for micromarketing and increasing sophistication
• 2000's saw targeted advertising of online activity

Advertising and Competition

• Firms primarily use it, but the importance can vary based on the market structure
  • Perfect competition has perfect information and no need
  • Monopoly: limited scope, to increase total demand
  • Oligopoly: as a non-price form competition, strong incentives to advertise

Advertising Reasons

• Reasons for advertising include:
  • Launching a product or service
  • Providing information on price and quality
  • Increasing or preserving market share
  • Establishing brand image or strengthening consumer loyalty

Advertising Expenditure Factors

• Advertising is roughly 1% of GDP
• Informative advertising contains factual information about a product’s existence or characteristics (price, location of sales, discounts, product features, quality, tests, etc.)
• Persuasive advertising makes non-verifiable claims to change consumers' perceptions of a product, service or brand with a view to stimulating sales
  • can also shift consumer tastes, or "mislead, confuse, and distort"
• Clear distinction may not be possible, simultaneous functions in ads What companies want should not be considered a delusion - companies produce products consumers want

Advertising and Product Characteristics

• Product characteristics determine the intensity of advertising, such as if the product can beaccurately assessed, purchased frequently, and how expensive the product is
• Nelson assessment of attributes:
  • Search goods can be determined prior to purchase, with informative ads on price, existence, capabilities, and location
  • Experience goods attributes can only be determined when they are consumed with persuasive and informative advertising
• Darby and Karni, Mixon - credence goods' quality cannot be assessed before or after consumption, and requires specialized knowledge like medical care, car repair, dental services
• Arterburn and Woodbury describes the frequency of
  • convenience goods, purchased frequently such as cheap goods
  • shopping goods, purchased infrequently such as expensive goods
• Advertisement: high quality brand attracts repeated purchases, which can signals quality

Advertising Intensity

• Advertising intensity or advertising-to-sales ratio (ASR) helps determine the amount to advertise
• This indicates a form of non-price competition

Advertising as a Barrier

• Having advertising increases start-up costs
• High advertising creates reputation effects
  • Pioneering firms are often able to shape consumer tastes in favor of their own products or brands
• Economies of scale in advertising
  • Must advertise a certain times before producing increased sales
  • Large scale advertisers may pay less per unit of advertising
  • Indirect 'distribution effect' when retail increases stocks of products in response to maker's advertisement campaign for demand

Advertising Response

• Advertising reflects responsiveness of sales to advertising expenditure
• Entrant advertising describes its product or brand for the first time to reach threshold
• Incumbent advertising is assumed to have already been effective in building customer loyalty
• Incumbent has an absolute advantage on costs

Advertising and Information

• Information asymmetry or imperfect information means advertising improves information search speed and efficiency
• Search process has costs and demands time
• Advertising obtains information effectively, cheaper, and faster

Signalling Quality

• Markets for product with HQ and LQ brands can cause adverse selection
• Kihlstrom and Riordan, and Milgrom and Roberts found that repeated purchases from HQ builds advertising, signalling quality
  • LQ is not worthwhile to advertise (as HQ)
  • If HQ brands advertise, it will lead to repeated purchases
• The ad itself (not the message), is a signal (assumes ad costs are observable)
• Producers advertise if they know if product will attract repeated purchases
• Not advertising may be signal of low quality

Quality Signals

• Other quality signals factors include:
  • Price, when quality differences are large
  • CSR policies: as quality signals for credibility
    • Credence services have a 23% likelihood of using CSR
    • Durable experience goods have a 15% likelihood
    • Experience services or non-durable goods: no change

Kaldor vs Telser Ideas

• Kaldor's critique is that advertising comes with goods and services, so consumers have to pay for advertising when they do not want it
  • Ads provide free service, but there is oversupply
  • Consistent standard of micro, static preferences, and perfect information
• Telser says that if consumers does not buy advertised goods, there is no market for ads
• Savings from joint supply of advertisement stem from goods and provisions, which would be costly

Alternative View

• Dynamic societies mean tastes are conditioned socially and culturally, so demand is endogenous rather than exogenous
• Stigler, Telser, Littlechild, Nelson believe advertising provides valuable information leading to rational choices
  • Knowledge and product attributes
  • Only informed consumers will buy better
• Becker and Murphy believes ads are valuable complements

Dixit vs Norman

• Welfare effects are difficult to analyze since ads can change preferences
• Dixit and Norman says if welfare increases with pre and post advertising, it will increase unambiguously

Evidence

• Abernethy and Franke found "cues"/ad average at 2.04
• Not a strong relationship between concentration and advertising intensity
• Paton and Vaughan Williams found a positive relationship between profitability and advertising, Greuner found no relationship, Notta found only TV ads increased profitability
• Eckard shows how intensive ads can destabilize market share and overall rankings
• Some find a strong relationship between advertising and product quality
• Ads often can reduce prices