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11: Signals, Advertising, and Market Competition

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    Learning Objectives

    The specific objectives of this chapter are as follows:

    • Explain the problems of adverse selection and moral hazard that result from information asymmetries.
    • Explain the role of advertising to facilitate transactions that involve costly information, asymmetric information, or some combination of the two.
    • Distinguish between default-independent and default-contingent signals, provide examples of each, and describe situations where each may be effective.
    • Explain the concept of a separating equilibrium and why it is important to the functioning of economic signals.

    In many economic models, it is assumed that information is freely available. For example, in the neoclassical model of the consumer covered in Chapter 5, the consumer knew prices and the amount of satisfaction that would derived from purchased goods. In Lancaster’s model or Becker’s model, the consumer knew even more and could ascertain the amounts of characteristics that were inherent in purchased goods or the time commitments required for household production. Moreover, both the buyer and seller were equally informed about characteristics of the product. In many real world cases, information is not freely available. Information is costly to obtain and a buyer must search for availability of goods and the prices at which they are being offered. Moreover, it is often difficult to judge, pre-purchase, how much of a given characteristic a product will contain.

    If information is necessary for economic decision making and is costly, then it might be interesting to subject it to more formal analysis. In fact, economic analysis of information has been one of the most productive areas in the past few decades. The focus in this chapter will be necessarily brief with the overall aims being (1) to shed light on some primary information problems in the functioning of markets and (2) to emphasize the roles that advertising and other activities can play in solving these problems.

    • 11.1: Overview and Objectives
      This page explores the assumption of freely available information in economic models versus the reality of costly information. It highlights two primary issues—adverse selection and moral hazard—arising from information asymmetries in markets. The chapter focuses on analyzing these challenges and the role of advertising in addressing them.
    • 11.2: Asymmetric Information
      This page discusses asymmetric information in transactions, where one party has more information, potentially causing market failures. Akerlof's "lemons market" illustrates how this leads to low-quality products due to buyer inability to assess quality. The page identifies two issues: adverse selection, which hinders mutually beneficial trades, and moral hazard, pertaining to post-contractual risks.
    • 11.3: Advertising
      Advertising is a huge industry, with billions spent every year on marketing products. Are these enormous expenditures worth it? The benefits of increased sales and revenues must be at least as large as the increased costs to make it a good investment. In this section, the profit-maximizing level of advertising will be identified and evaluated.
    • 11.4: Advertising as Information
      This page discusses the undervaluation of advertising in economic analysis, traditionally viewed as a means of manipulating consumer preferences. It highlights advertising's essential role in resolving informational imbalances in markets by informing consumers of search characteristics and signaling quality for experience characteristics. It emphasizes that significant advertising investments can reassure consumers about product quality, thereby influencing their purchasing decisions.
    • 11.5: Market Signals to Counteract Asymmetric Information Problems
      This page examines how advertising and pricing strategies function as economic signals to address asymmetric information between firms and consumers. It categorizes signals into default-independent signals (e.g., advertising, low initial prices) that require upfront investments for future profitability, and default-contingent signals (e.g., warranties) that incur costs only when low quality is proven.
    • 11.6: A Formal Model of Signals
      This page examines market dynamics involving high-quality and low-quality firms amid asymmetric information, resulting in potential market failures like lemons markets. It highlights the role of signals, such as warranties and advertising, to differentiate high-quality firms, emphasizing that effective signals must be less costly for honest firms.
    • 11.7: Concluding Comments
      This page discusses the dual impact of advertising in economics. While it is traditionally seen as reducing demand elasticity and enhancing sellers' market power in imperfectly competitive markets, recent insights reveal its positive role. Advertising aids consumer search and signals product attributes, contributing to market efficiency by addressing asymmetric information.
    • 11.8: References
      This page examines influential works on market dynamics and signaling in economics, highlighting Akerlof's exploration of quality uncertainty, Kirmani and Rao's literature review on signaling, Milgrom and Roberts' connections between economics and management, and Nelson's analysis of advertising as a quality signal. Collectively, these contributions deepen the understanding of information asymmetry in markets.
    • 11.9: Problem Sets
      This page explores economic signaling, focusing on adverse selection and the role of signals in differentiating product quality. It provides exercises examining scenarios where truthful claims and signaling can enhance profitability and reduce deception among firms. Key concepts include asymmetric information, default-contingent and -independent signals, and separating equilibrium.

    This page titled 11: Signals, Advertising, and Market Competition is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Michael R. Thomsen via source content that was edited to the style and standards of the LibreTexts platform.