Advertising, until recent decades, has been fairly neglected in economic analysis. It is probably safe to say that economists saw advertising as an obvious way for sellers to influence consumer tastes and preferences. It was taken for granted that the purpose of advertising was to make the demand curve less elastic and provide sellers with more discretion in setting prices. There is probably truth in this. However, recent work has shown that advertising can do much to overcome informational problems in markets and, hence, can be valuable in helping markets function and in improving the efficiency of the economic allocation problem. In a classic article, Nelson (1974) noted that the messages conveyed in advertising activities depend on whether the good being advertised has search characteristics or experience characteristics.
Search characteristics refer to aspects of a product that can readily be assessed by inspection prior to sale. There is no asymmetric information problem with search characteristics. Customers have access to the same information as the seller. However, knowledge about search characteristics could be costly information because finding out about search characteristics might require effort on part of the consumer. Thus, advertising could play a role in reducing search costs to consumers. Unlike search characteristics, experience characteristics are known to customers only through use of the product and cannot be determined by inspection prior to sale. Asymmetric information can be a major problem when it comes to experience characteristics.
To better develop the distinction between search and experience characteristics, consider corn flakes. A box of corn flakes at the supermarket contains both search characteristics and experience characteristics. Assuming that labeling regulations are effective and adequately enforced, the consumer can look at the box to determine how many ounces it contains, the ingredients that were used in the manufacture of the product, a date that provides information about the product’s freshness, and the nutrients that the product will provide. Each of these is a search characteristic. The customer does not need to buy the product to be fully informed about characteristics such as these. A consumer might have other questions about the corn flakes such as: Will they have a rich toasted corn flavor? Are they crunchy, and will they stay crunchy after milk is added? Will the corn flakes pair well with a handful of fresh blueberries? These are all questions about experience characteristics. There is no way for the consumer to be sure about the taste and texture attributes of the cornflakes until after the cornflakes leave the store and he or she consumes them.
Advertising Can Address Both Search and Experience Characteristics
Advertising can clearly play a role when it comes to helping consumers become informed about search characteristics. Advertising can inform consumers that a product exists and provide information about its price and search attribute. This can lower the cost that consumers would otherwise face in their search for information and can help the economy work smoothly. However, many advertising messages do not seem to be doing anything that would aid in information search.
For example, anyone in the United States, and most of the world for that matter, knows that Coca-Cola is a soft drink available for purchase almost anywhere at any time. Most people do not need an advertising message to let them know Coca-Cola exists, tastes sweet, is carbonated, and provides caffeine. Occasionally Coca-Cola may come out with a new flavor variation, e.g., vanilla-flavored Coke. In such instances, it might facilitate consumer search to have an advertising campaign informing consumers that a new vanilla-flavored variation of Coca-Cola is available. Similarly, a retail establishment might offer a temporary price reduction on Coca-Cola products. Consumer search would be aided if an advertising message provided information about this change in price.
These exceptions aside, most advertisements for soft drinks like Coca-Cola do not convey material information about product availability, search attributes or price. Most consumers would find it hard to believe that Coca-Cola plays a central role in the recreational excursions of polar bear families as depicted in a recent Super Bowl advertisement. Why would Coca-Cola spend the enormous sum of money that it takes to develop and run an add on the Superbowl that ultimately does little to reduce search costs? Nelson (1974) provides a compelling explanation.
Nelson’s (1974) main argument is that when it comes to experience characteristics, advertising is informative. The mere fact that a seller advertises provides information about experience characteristics, even if the content of the advertisement does not explicitly mention the characteristic. As shown below, Nelson’s (1974) basic idea can be formalized using an economic model that shows an equilibrium wherein high-quality producers choose to advertise and low-quality producers choose to not advertise. In this model, “high quality” will refer to products containing experience characteristics for which consumers are willing to pay a premium.
The Logic of Advertising as a Signal
Let us consider a market with the following features:
- There is asymmetric information wherein sellers have more information about the quality of their products than do buyers.
- Buyers are aware that they have less information and are naturally wary of adverse selection problems. As a result, buyers discount quality claims made by sellers.
The high-quality seller needs some way to convince the skeptical buyer that the product she is selling indeed does provide high quality. If she cannot convince buyers of her high quality, she cannot sell at the high-quality price and will not be willing to incur extra costs required to produce high-quality products. The high-quality seller must convince the buyer that it would be against her interest to use asymmetric information to her advantage. That is, the seller needs to convince buyers that it would not make sense for her to charge a high-quality price for a low-quality product.
An extravagant advertising campaign is something that is visible to the buyer and something that the buyer will presumably understand to be costly. The buyer might reason that if the seller is spending a great deal of money on an advertisement, the seller must have good quality because the only way to recoup the advertising outlay would be to generate repeat purchases. If quality is bad, repeat purchases would not materialize, and the seller would not recover advertising costs. Hence, firms that advertise must be those who are providing high quality. As explained in more detail below, under certain conditions expenditures on things like advertising can serve as an irredeemable bond that commits the seller to high quality. Advertising is one example of a signaling mechanism that could potentially overcome adverse selection problems that result from asymmetric information.
