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Chapter 17: Q1E (page 645)

Question:Many consumers view a well-known brand name as asignal of quality and will pay more for a brand-nameproduct (e.g., Bayer aspirin instead of generic aspirin,or Birds Eye frozen vegetables instead of the supermarket’sown brand). Can a brand name provide auseful signal of quality? Why or why not?

Short Answer

Expert verified

The brand name acts as the signal of quality since it removes the problem of asymmetric information; the producer incurs a huge cost on the advertisement to create a brand name that depicts it as of higher quality.

Step by step solution

01

Brand names as a signal of quality

Brand names are a very good signal of quality. A brand name removes the asymmetry in the information between buyers and sellers. Since a customer is generally unaware of the quality of the various similar but differentiated products in the market, the brand's name helps them develop trust and buy a product whose quality is guaranteed by the company.

The producers usually incur a huge cost for advertisement and marketing, which helps them spread awareness about the brand. Aproducer will never incur a huge sum to sell a bad-quality product. This would not help them in retaining their customers, and it will be an unnecessary cost. Therefore, advertising is mostly done to promote the sale of good quality products.

Thus, a brand name created through advertising signals a good quality.

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Most popular questions from this chapter

You have seen how asymmetric information can reduce the average quality of products sold in a market, as low-quality products drive out high-quality products. For those markets in which asymmetric information is prevalent, would you agree or disagree with

each of the following? Explain briefly:

a. The government should subsidize ConsumerReports.

b. The government should impose quality standards—e.g., firms should not be allowed to sell low-quality items.

c. The producer of a high-quality good will probably want to offer an extensive warranty.

d. The government should require all firms to offer extensive warranties.

Two used car dealerships compete for side by side on a main road. The first, Harry’s Cars, always sells high-quality cars that it carefully inspects and, if necessary, services. On average, it costs Harry’s \(8000to buy and service each car that it sells. The second dealership, Lew’s Motors, always sells lower-quality cars. On average, it costs Lew’s only \)5000 for each

car that it sells. If consumers knew the quality of the used cars they were buying, they would pay \(10,000on average for Harry’s cars and only \)7000 on average for Lew’s cars.

Without more information, consumers do not know the quality of each dealership’s cars. In this case, they would figure that they have a 50–50 chance of ending up with a high-quality car and are thus willing to pay \(8500 for a car.

Harry has an idea: He will offer a bumper-to-bumper warranty for all cars that he sells. He knows that a warranty lastingYyear will cost \)500Yon average, and he also knows that if Lew tries to offer the same warranty, it will cost Lew $1000Yon average.

a. Suppose Harry offers a one-year warranty on all of the cars he sells.

i. What is Lew’s profit if he does not offer a one-year warranty? If he does offer a one-year warranty?

ii. What is Harry’s profit if Lew does not offer a one-year warranty? If he does offer a one-year

warranty?

iii. Will Lew’s match Harry’s one-year warranty?

iv. Is it a good idea for Harry to offer a one-year warranty?

b. What if Harry offers a two-year warranty? Will this offer generate a credible signal of quality? What about a three-year warranty?

c. If you were advising Harry, how long a warranty would you urge him to offer? Explain why.

To promote competition and consumer welfare, the Federal Trade Commission requires firms to advertise truthfully. How does truth in advertising promote competition? Why would a market be less competitive if firms advertised deceptively?

Question:A major university bans the assignment of D or Fgrades. It defends its action by claiming that studentstend to perform above average when they are freefrom the pressures of flunking out. The universitystates that it wants all its students to get As and Bs.If the goal is to raise overall grades to the B level orabove, is this a good policy? Discuss this policy withrespect to the problem of moral hazard.

An insurance company is considering issuing three types of fire insurance policies: (i) complete insurance coverage,(ii) complete coverage above and beyond a $10,000 deductible,

and (iii) 90 percent coverage of all losses. Which policy is more likely to create moral hazard problems?
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