14. f. Advertising, Brand Names and Product Quality:
With advertisements come the benefit to the firm of a brand name image, but there are also sunk costs that the firm faces when promoting their product. Firms of high-quality products want to inform the consumers that their product is good, so they engage in advertisements. Through customer satisfaction and word of mouth, customers will feel confident buying from a high-quality firm. Firms of low-quality products also want the benefits of advertisement, but consumers will only fall for a low-quality firm’s claim once. This generates a ‘one-time profit’ for the low-quality firm. Low-quality products can be produced at a much lower cost, so there is an incentive to buy low quality and sell at a high-quality price.
Figure 14.f.1. Initial high-quality equilibrium occurs where the MC curve AC curve and P0 intersect. Firms that buy low-quality products and sell at high-quality prices make a one-time profit of ABCD (this is the incentive for a low-quality firm to cheat). At this point, MC-Low Quality intersects with P0 and follows down until it touches the AC-Low Quality curve. Producers of high-quality goods would set a quality assurance price of P1 in which they incur unavoidable sunk costs (hence the higher price) through the use of advertising. With the advertising expenses, the AC curve eventually shifts up to AC’. The shaded area (purple) represents the honest, high-quality profit forever, where = 0. When > 0, this attracts rivals and eventually forces the price, as well as the profit down.
Case # 2:
Consider the lemons problem, based on a model by George A. Akerlof, in which a large percentage of goods may be lemons in a market where buyers are less informed of product quality than the sellers (also known as asymmetric information, where one side knows more information than the other).
Suppose that there are two markets for cars, Good Cars and Bad Cars in which we assume that buyers do not know the difference and the seller does. The buyer believes that there is a 50% chance that they could end up with either one. If a good car is $200, and a bad car is worth $100, then according to the assumptions above, the expected value of both cars comes to $150 (where a good car = 50%expectation*$200, and a lemon or bad car = 50% expectation*$100 to a combined total E.V. = $150).
In this example, the good car owners won’t sell for $150 because their car is worth more than that. This implies that the supply curve for higher-quality cars is upward sloping and that fewer units will be sold at the equilibrium price. The bad car owners are more than happy to get $150 for a car that is worth only $100. In a market situation like this, there will be no offer for good cars and only bad cars will be sold at a price of $100. This is a case where advertising will be one solution for the consumer, as a ‘good car’ dealer that knows his car is good will want to advertise to inform the customer. In the event that a ‘bad car’ dealer advertises a lemon, the consumer will never buy that product again—so the ‘bad car’ dealer ends up making a one-time profit.
Figure 14.f.2. The graph shows the price (PM) that a monopoly charges to produce quantity QM, and the extra costs that a firm will face in order to raise the quality of the product. The MC-quality curve is a different curve that includes a higher quality product by the firm.