Academic journal article Economic Inquiry

Advertising and Product Quality in Posted-Offer Experiments

Academic journal article Economic Inquiry

Advertising and Product Quality in Posted-Offer Experiments

Article excerpt

ADVERTISING AND PRODUCT QUALITY IN POSTED-OFFER EXPERIMENTS

I. INTRODUCTION

For years the Federal Trade Commission (FTC) has attacked unfair and deceptive advertising. Recently it has turned its attention to errors of omission rather than commission, by challenging agreements among sellers to limit advertising even when it is truthful. One reason for eliminating advertising restrictions is to stimulate competition in the advertised dimension of the good or service. For example, price advertising may result in more price competition. On the other hand, professional associations argue that price competition causes product quality to deteriorate because sellers of high quality services are forced to match the lower prices of sellers of low quality products. And through their codes, professional associations have implicitly or explicitly discouraged some forms of advertising, including price advertising. Restrictions of this nature still exist in some local markets, although they have become the subject of FTC litigation. [1]

The quality deterioration argument of professional associations is plausible only when buyers are unable to observe quality prior to purchase. [2] When buyers cannot distinguish quality, moral hazard invites sellers to lower cost by providing lower quality. Adverse selection can result from price advertising, causing lower cost products to drive out higher cost products as argued by Akerlof [1970]. The opposite point of view is that even when quality cannot be determined prior to purchase, price advertising may enable sellers to signal quality and develop reputations. [3] Moreover, transactions repeatedly involving the same buyers and sellers may enable buyers to form expectations about seller quality based on their experience. That can make it worthwhile for a seller to provide higher quality.

The series of laboratory experiments described here permits the evaluation of market performance when buyers have very limited information. The claim to be investigated is that price advertising prevents quality deterioration and improves market efficiency. Reputation formation through advertising is emphasized instead of other mechanisms, such as warranties, that may prevent quality deterioration. [4]

So that quality can be kept relatively neutral and easily understood by subjects, we represent it as the "grade" of a commodity. The structure underlying the experiments is based on Holt's model of the determination of industry quality, which is summarized in Schmalensee (1979). Demand is induced through the values for which buyers can redeem their purchases. Value is linearly related to grade, so that no difference between average and marginal valuation of quality can arise to cause nonoptimal quality, as it did in Spence (1976). The production cost for each seller is quadratic in the grade selected by the seller. Therefore, the efficient grade level is unique.

The most closely related experimental work on product quality decisions is reported in Lynch, Miller, Plott and Porter (1986). In their experiments, sellers chose one of two quality levels. Prices were determined in an oral double auction. Efficient price and quality outcomes resulted when prospective buyers were given full information about quality. Removing the identities of sellers and allowing only post-purchase quality information sometimes resulted in a "lemons outcome" in which sellers offer a low-quality product, even though the market would be more efficient with the production and sale of a high-quality product. Private information tended to yield less efficient outcomes than full public information.

The posted-offer experiments reported in this paper differ from the oral-double-auction experiments in Lynch, Miller, Plott, and Porter because one of our objectives was to examine the effect of advertising restrictions on market efficiency. In our experiments, price advertising is implemented in a standard posted-offer auction. …

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