Mechanisms to Reduce the Risk of Imperfect Information
Mechanisms to Reduce the Risk of Imperfect Information
If you were selling a good like emeralds or used cars where imperfect information is likely to be a problem, how could you reassure possible buyers? If you were buying a good where imperfect information is a problem, what would it take to reassure you? Buyers and sellers in the goods market rely on reputation as well as guarantees, warrantees, and service contracts to assure product quality; in the labor market, occupational licenses and certifications are used to assure competency, while in financial capital market cosigners and collateral are used as insurance against unforeseen, detrimental events.
In the goods market, the seller of a good might offer a money-back guarantee, an agreement that functions as a promise of quality. This strategy may be especially important for a company that sells goods through mail-order catalogs or over the web, whose customers cannot see the actual products, because it encourages people to buy something even if they are not certain they want to keep it.
L.L. Bean started using money-back-guarantees in 1911, when the founder stitched waterproof shoe rubbers together with leather shoe tops, and sold them as hunting shoes. He guaranteed satisfaction. However, the stitching came apart and, out of the first batch of 100 pairs that were sold, 90 pairs were returned. L.L. Bean took out a bank loan, repaired all of the shoes, and replaced them. The L.L. Bean reputation for customer satisfaction began to spread. Many firms today offer money-back-guarantees for a few weeks or months, but L.L. Bean offers a complete money-back guarantee. Anything you have bought from L.L. Bean can always be returned, no matter how many years later or what condition the product is in, for a full money-back guarantee.
L.L. Bean has very few stores. Instead, most of its sales are made by mail, telephone, or, now, through their website. For this kind of firm, imperfect information may be an especially difficult problem, because customers cannot see and touch what they are buying. A combination of a money-back guarantee and a reputation for quality can help for a mail-order firm to flourish.
Note: Visit this website to read about the origin of Eddie Bauer’s 100% customer satisfaction guarantee.
Sellers may offer a warranty, which is a promise to fix or replace the good, at least for a certain period of time. The seller may also offer a buyer a chance to buy a service contract, where the buyer pays an extra amount and the seller agrees to fix anything that goes wrong for a set time period. Service contracts are often used with large purchases such as cars, appliances and even houses.
Guarantees, warranties, and service contracts are examples of explicit reassurance that sellers provide. In many cases, firms also offer unstated guarantees. For example, some movie theaters might refund the cost of a ticket to a customer who walks out complaining about the show. Likewise, while restaurants do not generally advertise a money-back guarantee or exchange policies, many restaurants allow customers to exchange one dish for another or reduce the price of the bill if the customer is not satisfied.
The rationale for these policies is that firms want repeat customers, who in turn will recommend the business to others; as such, establishing a good reputation is of paramount importance. When buyers know that a firm is concerned about its reputation, they are less likely to worry about receiving a poor-quality product. For example, a well-established grocery store with a good reputation can often charge a higher price than a temporary stand at a local farmer’s market, where the buyer may never see the seller again.
Sellers of labor provide information through resumes, recommendations, school transcripts, and examples of their work. Occupational licenses are also used to establish quality in the labor market. Occupational licenses, which are typically issued by government agencies, show that a worker has completed a certain type of education or passed a certain test. Some of the professionals who must hold a license are doctors, teachers, nurses, engineers, accountants, and lawyers. In addition, most states require a license to work as a barber, an embalmer, a dietitian, a massage therapist, a hearing aid dealer, a counselor, an insurance agent, and a real estate broker. Some other jobs require a license in only one state. Minnesota requires a state license to be a field archeologist. North Dakota has a state license for bait retailers. In Louisiana, a state license is needed to be a “stress analyst” and California requires a state license to be a furniture upholsterer. According to a 2013 study from the University of Chicago, about 29% of U.S. workers have jobs that require occupational licenses.
Occupational licenses have their downside as well, as they represent a barrier to entry to certain industries. This makes it more difficult for new entrants to compete with incumbents, which can lead to higher prices and less consumer choice. In industries that require licenses, the government has decided that the additional information provided by licenses outweighs the negative effect on competition.
Are advertisers allowed to benefit from imperfect information?
Many advertisements seem full of imperfect information—at least by what they imply. Driving a certain car, drinking a particular soda, or wearing a certain shoe are all unlikely to bring fashionable friends and fun automatically, if at all. The government rules on advertising, enforced by the Federal Trade Commission (FTC), allow advertising to contain a certain amount of exaggeration about the general delight of using a product. They, however, also demand that if a claim is presented as a fact, it must be true.
Legally, deceptive advertising dates back to the 1950s when Colgate-Palmolive created a television advertisement that seemed to show Rapid Shave shaving cream being spread on sandpaper and then the sand was shaved off the sandpaper. What the television advertisement actually showed was sand sprinkled on Plexiglas—without glue—and then scraped aside by the razor.
In the 1960s, in magazine advertisements for Campbell’s vegetable soup, the company was having problems getting an appetizing picture of the soup, because the vegetables kept sinking. So they filled a bowl with marbles and poured the soup over the top, so that the bowl appeared to be crammed with vegetables.
In the late 1980s, the Volvo Company filmed a television advertisement that showed a monster truck driving over cars, crunching their roofs—all except for the Volvo, which did not crush. However, the FTC found in 1991 that the roof of the Volvo used in the filming had been reinforced with an extra steel framework, while the roof supports on the other car brands had been cut.
The Wonder Bread Company ran television advertisements featuring “Professor Wonder,” who said that because Wonder Bread contained extra calcium, it would help children’s minds work better and improve their memory. The FTC objected, and in 2002 the company agreed to stop running the advertisements.
As can be seen in each of these cases, factual claims about the product’s performance are often checked, at least to some extent, by the Federal Trade Commission. Language and images that are exaggerated or ambiguous, but not actually false, are allowed in advertising. Untrue “facts” are not allowed. In any case, an old Latin saying applies when watching advertisements: Caveat emptor—that is, “let the buyer beware.”
On the buyer’s side of the labor market, a standard precaution against hiring a “lemon” of an employee is to specify that the first few months of employment are officially a trial or probationary period, and that the worker can be let go for any reason or no reason after that time. Sometimes workers also receive lower pay during this trial period.
In the financial capital market, before a bank makes a loan, it requires a prospective borrower fill out forms regarding the sources of income; in addition, the bank conducts a credit check on the individual’s past borrowing. Another approach is to require a cosigner on a loan; that is, another person or firm who legally pledges to repay some or all of the money if the original borrower does not do so. Yet another approach is to require collateral, often property or equipment that the bank would have a right to seize and sell if the loan is not repaid.
Buyers of goods and services cannot possibly become experts in evaluating the quality of gemstones, used cars, lawyers, and everything else they buy. Employers and lenders cannot be perfectly omniscient about whether possible workers will turn out well or potential borrowers will repay loans on time. But the mechanisms mentioned above can reduce the risks associated with imperfect information so that the buyer and seller are willing to proceed.
This lesson is part of:
Information, Risk, and Insurance