Tuesday, May 09, 2006

On Advertising

In this elegantly written article from 1997, John Kay describes how Economists’ attitudes towards advertising have changed. Early 20th century Economists shared a common prejudice against advertising. This began to change in 1970, when the Quarterly Journal of Economics published a 13-page paper that won George Akerlof the 2001 Nobel Prize in Economics. This after The American Economic Review, The Review of Economic Studies, and the Journal of Political Economy had all rejected the paper- the first two said that the paper was too trivial to be worth publishing, and the third that if the paper were correct, then Economic Theory would have to be changed.
Tim Harford discusses the same paper here .
The basic idea is remarkably simple. Imagine there is a market for some good which varies in its quality. For simplicity, assume that there are just 2 quality grades- some are exceptionally good (Peaches), others are exceptionally bad (Lemons). Buyers would pay Rs 1000 for the peaches, but only Rs 100 for the lemons. Sellers would happily sell a peach for Rs 800, and a lemon for Rs 40. 50 per cent of the goods are peaches, 50 per cent are lemons (all these assumptions can be relaxed in more complex models).
Under these circumstances, you would expect the sellers and buyers to both be happy- they trade peaches for some price between Rs 800 and Rs 1000, and lemons for some price between Rs 40 and Rs 50.
However, assume that sellers know whether their goods are peaches or lemons, but the buyers cannot tell. Now, imagine that you are a buyer. You know that you have a 50 per cent chance of ending up with a lemon. Hence, you are willing to pay no more than Rs 550 (=0.5*1000+0.5*100) for the product. At this price, you will come out ok in the long run. This is true for all buyers.
However, no seller would sell a peach at that price. All those who have peaches and would like to sell them withdraw from the market, leaving only those who have lemons to sell. The buyers quickly realize that they are ending up with far more lemons than they expected, and further drop the price that they would be willing to pay. This downward spiral ends until buyers pay no more than Rs 40, and only lemons remain in the market.
This is a market failure- you have people who want to sell something (the peaches), and people who want to buy what they have to sell, and the two can even agree on the price, but no trade results.
What can save the situation is if those who have the peaches can somehow signal to the buyers the true condition of their goods, and if the signal is either somehow impossible to fake, or if it is one that those who have lemons would not find it worthwhile to mimic.
How can this be arranged? Well, just one solution is that I could arrange to sell my peach to an intermediary who has the means to inspect my goods and evaluate its worth- a car dealer in the case of second-hand cars. The dealer, by investing in his brand through heavy advertising, an expensive showroom in an exclusive part of town, and so on, signals to potential buyers that he has made a major investment in the market and needs lots of referrals and repeat customers to recoup that investment. He can thus be trusted to care about his customers’ interests. Similarly in any market where one participant (apartments, loans, insurance, understands the quality of the product better than the other (Asymmetric information).
That brings us back to John Kay’s article.
What do you think? Comments from those who have experience of these matters would be especially welcome. :-)

1 comment:

amma :-) said...

Kurachchu prayaasam argument follow cheyyaan,sentences kurachchu long aayi poyille'?