Lemon economics

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Tobacco companies are allowed to make no claims for their product at all, except that it is bad for you. An economist’s perspective on advertising may explain why.

When I learnt economics as a student, I was taught to take a dim view of advertising. In Economics 1, I had apples and you had pears. You wanted some apples and I wanted some pears, and that provided scope for beneficial exchange. A competitive market enabled each of us to trade apples for pears. That competitive market not only allowed exchange, but made sure it would be efficient.

So where did advertising come into this? It didn’t. Shouting “eat apples” or “eat pears” created no more apples and pears, and indeed you had to feed apples and pears to the advertising agencies who did the shouting. And proclaiming “eat Bloggs’ apples” or “eat Smith’s pears” would. If successful, simply create market power and destroy the efficiency of a competitive market. Advertising was divided into the informative – apples are round and red and are available from greengrocers – and the persuasive – eat more apples. The informative might be tolerated in modest quantity. The persuasive served no beneficial economic purpose. The standard text on the economics of advertising was a work by Lord Kaldor, economic guru of the last Labour government but one. Kaldor regarded advertising as a sinful activity which should be heavily taxed, like smoking, drinking, gambling, and employment in service industries.

And the advertising industry did not help itself much by the way it described itself. Be handsome in Levis, seductive with Chanel, pull more birds in a Peugeot. It seemed to appeal to essentially irrational instincts and less than admirable ones. It employed economists of doubtful virtue to argue that advertising helped secure scale economies and promoted economic growth. But if I didn’t know I needed an underarm deodorant, how am I better off when you both create and satisfy my unnecessary demand?

What you learn in an economics course today would be very different. A whole new subject has been created called the economics of information. A seminal article by George Akerlof described the market for lemons. Akerlof did not simply extend the apples and pears model to cover citrus fruit. Akerlof’s lemon was a car made on a Friday afternoon in which nothing ever quite worked properly. (This was before the days when cars were made in Japan and just as good on Friday as on any other day of the week.) You as a seller knew whether or not your car was a lemon. The prospective purchaser did not.

Akerlof’s achievement for which he should get a prize some day, was to show that the economist’s assumptions about market efficiency ceased to be valid in the face of differences in information. Lemons illustrated the problem well. Suppose 10% of all cars were lemons. You might expect the price of a second hand car to reflect the frequency of lemons in the overall car population. But if it did, then selling at that price would be attractive to the owners of lemons and unattractive to the owners of normal cars. So there would be a disproportionate number of lemons in the used car showrooms.

Realising this, buyers would reduce the price they were willing to pay. But the result is that only those with really dreadful cars, or who are desperate for money, will put their cars on the market. The new price will not be low enough to reflect the original quality of the cars. In the end, there may be very little trade at very low prices. The market simply does not work.

One of the merits of Akerlof’s analysis was that it met a test failed by too many economic models – consistency with common sense. After all, everyone knows that buying a used car is a depressing experience.

With the economics of information came a different view of the economic role of advertising. Modern economies include many activities, like selling cars, where product quality and product attributes are complex and sellers know far more about what they sell than buyers about what they buy. Advertising is about managing that gap in information. And when you look more closely at advertising with that perspective, you see that the distinction between information and persuasion does not really stand up.

Much advertising – indeed all of the most conspicuous and costly advertising – was neither informative or persuasive. If you look at early twentieth century advertisements, you see that they were full of positive statements about the products they promoted. Coke was refreshing, healthful, the preferred drink of ladies. Today, all we learn is that “Coke is it”. Tobacco advertising demonstrates that you can still advertise extensively – and presumably successfully – when you are not allowed to make any claims for the product at all, other than that it is bad for you.

So what was such advertising for? It was Richard Nelson who noted that the only information such advertising conveyed was that the advertiser spent a lot of money on advertising. But, he argued, this is useful information. It tells you that the advertiser is committed to the product and the market. If he was not, it would be absurd for him to spend so much. And if he is committed to the product and the market, it also makes sense for him to devote resources to ensuring the quality of his product.

So consumers are right to believe that branded products are of good quality, not because the manufacturer claims they are good quality – mostly they do not – but because there is little point in branding products that are not. And many of the products which are most heavily advertised are those for which Akerlof’s information asymmetry is a problem – financial services, lavatory cleaners.

But not used cars. In that market, people don’t buy often enough for commitment to the market to be proved worthwhile. The market for lemons is real.

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