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and explains how modern e-businesses such as Amazon, Facebook, and Netflix are transforming the shopping problem.

THE “SHOPPING PROBLEM”

The consumer’s shopping problem is to find the seller offering the highest B 2 P (benefit minus price). The process of finding that seller is known as search. Consumers may search sequentially, learning about one seller at a time, or they may search simultaneously, learning about many products at once. Sequential search is characteristic of many consumer goods such as clothing and furniture. For these products, search is costly relative to B 2 P, usually because it involves considerable time and travel. A consumer who searches sequentially will often have a “threshold” B 2 P in mind and will buy from the first seller exceeding the threshold. Consumers who search sequentially do not always find the product offering the highest possible B 2 P because they may stop searching before then. Consumers may revise their threshold B 2 P during the course of sequential search if they learn that they were unrealistic about the level of B 2 P available in the market. This often occurs with clothing shopping, where consumers try on several outfits at different stores and then return to purchase from stores where they had previously searched.

In many cases the cost of search is relatively low compared to B 2 P and consumers will prefer to search simultaneously, gathering information about many products before deciding which one to purchase. Most prospective auto buyers and homeowners engage in simultaneous search. Because the Internet can greatly reduce search costs, many consumers have transitioned from sequential to simultaneous search for less costly goods such as athletic footwear, printers, and musical instruments. Simultaneous search assures consumers that they will find a product offering a high level of B 2 P. It also assures companies that those firms offering high B 2 P will enjoy a high market share. Using the terminology introduced in the Economics Primer, a reduction in search costs increases the elasticity of demand facing sellers.

It is not enough for consumers to seek out information about product attributes; they must also obtain, interpret, and understand the information. Products for which consumers can easily obtain the information required to compare alternatives are called search goods.2 Gasoline is a quintessential example of a search good—rightly or wrongly, consumers believe that all gasolines are pretty much identical, and they usually purchase from the gas station posting the lowest price regardless of brand. There are two classes of goods whose benefits are more difficult to evaluate. First, consumers may not learn the full value of experience goods until after purchase. Most consumer products as well as nearly all personal services are experience goods. Second, consumers may never fully learn about credence goods, even after purchase. Table 10.1 summarizes the distinctions among search, experience, and credence goods and provides examples of each.

Whether shopping for search, experience, or credence goods, consumers value information. They want to know gasoline prices, learn about the fuel economy of automobiles, compare the on-time arrival rates of different airlines, and choose a primary care physician with good diagnostic skills. Sellers of search goods like gasoline can make it easy for consumers by prominently posting prices. Sellers of experience goods can help consumers by voluntarily disclosing quality (as opposed

to relying on a third-party certifier to report the information). Toyota brags about the fuel economy of its Prius hybrid car. Southwest Airlines advertises its industryleading on-time arrival rates. Physicians put their diplomas on their waiting room walls. Disclosing the quality of credence goods is difficult, if not impossible. Air travelers take it on faith that their planes are properly maintained for safety, and patients usually assume that their primary care physicians have made the right diagnoses.

Unraveling

One might expect all high-quality vertically differentiated sellers to follow the lead of Toyota and Southwest and voluntarily disclose their quality. A simple economic theory suggests that under the right conditions, even low-quality sellers will disclose. To illustrate the theory, consider 10 hospitals that have measured the cardiac surgery mortality rates of their own cardiovascular surgeons. Heart surgery patients (and their referring cardiologists) will prefer hospitals with lower mortality rates but may be unaware that there are differences among hospitals. If no hospitals disclose their quality, we can expect them to share patients fairly equally, with factors such as location playing a dominant role in admission patterns. The hospital with the lowest mortality rate will naturally wish to disclose in order to boost its share. Once the best hospital has disclosed, patients who do not go to that hospital will divide themselves among the remaining nine. By the same logic, the second best hospital will wish to disclose in order to separate from the pack, followed by the third best, the fourth best, and so forth. When the top eight hospitals have disclosed, the next to worst will also disclose so that it is not mistaken for the worst. Through this process of unraveling, patients learn the ranking of every hospital.

The theory of unraveling suggests that all firms, even the worst, will disclose their quality. This would leave no room for third-party certifiers, whose work would simply duplicate the voluntary disclosure. The reality is that voluntary disclosure is hardly universal and third-party certifiers play an important role in many

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markets. This is because theory requires several strong assumptions that are often violated in the real world. The theory requires sellers to cheaply and accurately assess their own quality and where they stand relative to other sellers; that is, the best sellers must know they are the best. If the best sellers are unaware of their superior product position, they may not set the unraveling in motion. The theory also assumes that consumers have reasonable beliefs about the distribution of quality. Otherwise, the best sellers may be reluctant to disclose unless everyone else does. For example, suppose that a hospital determines that its mortality rate for heart surgery is 1 percent—a very good rate. If patients believe that hospital mortality rates are usually much lower, then this hospital will be reluctant to disclose what ought to be considered good quality. Sellers may also be reluctant to disclose if they have not previously competed on quality. Calling attention to quality differences may increase consumer sensitivity to quality so that each seller ends up investing to improve its rankings. Unless sellers can pass these costs along through higher prices, they may earn lower profits than they did when consumers were unaware of quality differences.

Even when individual firms are reluctant to disclose, firms may collectively benefit if disclosure establishes consumer trust in the industry. In Chapter 1 we described how the Chicago Board of Trade established a system for grading and disclosing the quality of wheat in 1848. This facilitated the creation of futures markets by giving customers confidence about the quality of wheat they were committing to buy. The Joint Commission on the Accreditation of Healthcare Organizations (JCAHO) was formed 50 years ago by a consortium of health care providers in order to establish minimum quality standards for hospitals. Health insurers subsequently announced that they would only cover services provided at JCAHO accredited hospitals. In 1968, Hollywood film studios created the Classification and Rating Administration (CARA) to provide guidance to parents who may be concerned about the content of movies seen by their children. Disney Studios took advantage of the system by creating highquality movies with a G-rating, securing a dominant position in a previously underserved niche.

The movie studios created CARA to ward off government censorship. Indeed, when industries fail to voluntarily disclose quality, governments sometimes step in. Government-mandated disclosure in the United States began with the 1906 Pure Food and Drug Act, which mandated federal inspection of meat products and forbade the sale of poisonous medications. The 1963 Amendments to the Food and Drug Act were a direct response to Thalidomide (a sleeping pill that, if taken by pregnant women, could cause horrible deformities in newborns) and several other drugs that had severe side effects. The 1963 FDA Amendments set the standard for research-driven drug review that has been adopted worldwide. There are many other examples of government-mandated quality disclosure, and we will mention just a few:

•The 1934 U.S. Securities and Exchange Act requires public companies to file unaudited financial statements quarterly and audited financial statements annually.

•The 1968 U.S. Truth in Lending Act requires clear disclosure of key terms and all costs associated with a lending contract. Similarly, the European Union, Russia, Turkey, and the Arab States that make up the Gulf Cooperation Council use the International Financial Reporting Standards for audited financial statements.

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•The EU requires appliance retailers to display labels that rate products for energy consumption on a scale from A11 (best) to G (worst). In Japan, similar labels are required by local prefectures, while the U.S. Environmental Protection Agency issues “Energy Star” certification to ecofriendly appliances.

Governments can also establish minimum quality standards through licensing. In 1421, physicians petitioned the English Parliament to prohibit the practice of medicine by anyone lacking appropriate qualifications. In 1511, the parliament authorized bishops to regulate medicine, and in 1518 the College of Physicians was founded to license doctors in London. Six hundred years later, governments around the world require individuals to obtain licenses to practice medicine, law, architecture, acupuncture, hair coloring, and selling hot dogs from pushcarts. While licensing may set a quality floor, it also raises entry costs and protects incumbents from competition. For example, registered nurse anesthetists can perform nearly all of the same services as physician anesthesiologists. Even so, most nations restrict the ability of nurse anesthetists to practice without physician supervision and, as a result, they earn only a fraction of a physician anesthesiologist’s income.

Alternatives to Disclosure

Consumers may be skeptical when a firm boasts of its quality—such talk is cheap. Firms can back up their words by offering a warranty, which is a promise to reimburse the consumer if the product fails. A warranty is a form of insurance, as the expected cost of honoring the warrantee is often included in the purchase price. Such insurance can be very valuable for big-ticket items such as automobiles, where repair costs could make a dent in a family’s budget.

Of greater interest from the perspective of business strategy, warrantees also serve as a signal of quality. A signal is a message that conveys information about vertical positioning. A graduate from Harvard Law School may hold up her degree as a signal of quality. This is an effective signal because a third party (the law school) has certified the signaler through a rigorous screening process. Firms may attempt to signal their own quality through their public statements. But if other firms can utter the same claims, these signals may not be informative—consumers might not believe them. A signal is informative only if it is more profitable for the high-quality firm to offer the signal.3

In other words, if a high-quality firm can afford to take some action that a low-quality firm could not, then consumers can infer that any firm taking such an action must be of high quality.

What does signaling have to do with warrantees? Consider two automobile manufacturers, Acme and Lemona. Acme makes a reliable car that rarely breaks down. Lemona’s car is poorly designed, uses inferior components, and frequently breaks down. Acme expects to spend very little money honoring a five-year warranty. Lemona anticipates that honoring a five-year warranty would be very costly. Thus, the warranty fits the requirements of an informative signal: it is cheaper for Acme to offer the warranty than it is for Lemona. Taking our example to the real world, Hyundai made great strides penetrating a skeptical U.S. auto market when it offered an unprecedented 10-year new car warranty. Consumers liked the warranty for the peace of mind it offered (i.e., the warranty was a form of insurance). But many consumers correctly reasoned that Hyundai must make a durable car if it could afford to offer a 10-year warranty.