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associated with parties and good times. These associations help sell products that are otherwise barely differentiated from their rivals. But in some cases, branding can also serve as an alternative to disclosure by signaling the quality of vertically differentiated products.
Recall that a signal is informative if it is more profitable for a high-quality seller to give the signal. If advertising is a signal of quality, it must be the case that high-quality firms stand to gain more from advertising. Let us once again consider the two manufacturers, Acme and Lemona. Suppose that the two companies have ignored the lessons from Chapter 2 and have made unrelated diversifications into laundry detergent. Acme manufactures AirFresh detergent while Lemona makes LikeIt Detergent. These are experience goods; consumers can determine if the detergent cleans effectively after using it. Now consider a consumer choosing between AirFresh and LikeIt. When choosing between the two products, the consumer may reason as follows:
Advertising to promote a brand is costly. Acme is unlikely to recover its advertising expenses unless it sells a lot of AirFresh, and the only way that can happen is if it has a lot of satisfied customers making repeat purchases. It therefore stands to reason that AirFresh is a good cleaning detergent. On the other hand, Lemona has not advertised LikeIt at all. LikeIt could be a lousy product and Lemona could still make money, even if no one ever buys a second box. It is therefore much safer to buy AirFresh.
In other words, a high-quality seller of experience goods can afford to advertise, but a low-quality seller cannot. This is what makes advertising an effective signal. Because advertising is effective, sellers who advertise will attract more first-time purchasers. They can even charge higher prices, knowing that consumers will be suspicious of low-price competitors that do not advertise.
Most consumer goods manufacturers do not sell directly to consumers, finding it more efficient to distribute their products through independent retailers. Many of these retailers have their own brand reputations. Galleries Lafayette sells designer fashions; Fortnum and Mason’s carries gourmet foods; and Best Buy sells state-of-the- art electronics. Consumers may infer product quality from the reputation of the retailer or from the brands that they carry. As described in Example 10.2, this creates a tension that has the potential to transform value creation, and value capture, in many product sectors.
Nonprofit Firms
Consumers are skeptical of the quality of experience goods and, especially, credence goods because managers and owners of firms that offer low quality while masquerading as high quality stand to prosper. But if managers and owners are unable to profit from their deception, incentives to skimp on quality would disappear. Perhaps the best way for owners to eliminate this incentive is to establish themselves as nonprofit firms. Under tax law in most nations, nonprofits are not permitted to use any revenues in excess of costs (nonprofits do not talk of “profits”) to augment the compensation of owners and managers. Compensation may be tied to effort, training, and even to the accomplishment of specific goals, but not to excess returns.
Nonprofits are common in industries such as health care and education whose products may be described as credence goods. Consumers may gravitate to nonprofits in these industries precisely because they believe the nonprofit sellers will be less likely to skimp on quality.
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EXAMPLE 10.2 THE EVOLUTION OF BRANDING IN APPLIANCE RETAILING
The first “modern” washing machines that used a drum to remove and wash away dirt were invented in the latter half of the nineteenth century. Maytag, the first famous washing machine brand, began in 1893, and Whirlpool produced the first electric motordriven washers in 1911. The first washing machines were prone to break down and customers were naturally worried about servicing them. This helps explain why so many early appliance retailers began life as hardware stores: their proprietors possessed the kind of tinkering skills required to repair the finicky washers. In fact, repair service was so important that customers usually based their purchases more on the reputation of the local retailer than on the washer’s brand.
Things changed slightly in 1927 when Sears introduced the first Kenmore washer. Like all of its product offerings, Sears outsourced production of the Kenmore, and companies like Whirlpool and GE often sold more products under the Kenmore name than under their own label. Like the local appliance stores, Sears banked on customers who valued service, and this required Sears to work very hard with local store owners to assure uniformity of service quality. The strategy worked, as Sears sold over one million Kenmore washers within 10 years. For the better part of the next 40 years, retailing of washing machines and other appliances followed the same model—customers either shopped at their local appliance store or shopped at Sears. These stores had legions of loyal customers who valued customer service. The stores charged accordingly and profited handsomely.
Appliance retailing today bears little resemblance to this model. Nowadays, consumers are more apt to purchase washers and other big-ticket appliances from “big-box” retailers like Wal-Mart, Target, Sears, Lowe’s, and Home Depot. They buy consumer electronics from many of the same stores as well as Best Buy and Radio Shack. More and more consumers are shopping online from Amazon
and other outlets. Few of these outlets provide any service, and price competition is intense. Profits depend on inventory management and low-cost sourcing; customer loyalty counts for very little.
To understand why this industry has undergone such fundamental change, it is helpful to consider when these changes began to occur. Sears’s dominance as an appliance retailer began to slip in the 1960s. There were two important changes occurring at this time, both of which were out of Sears’s control. First, the quality and durability of home appliances improved dramatically, so that machines needed fewer repairs. Second, Americans had fallen in love with their televisions, which allowed firms to create national brands at low cost. In particular, this allowed appliance manufacturers to create brand identities quite apart from Sears. These two changes came together in one of the most memorable advertising campaigns of all time, Maytag’s “Loneliest Repairman in the World.” Consumers were no longer concerned about the quality of their repair service. They could purchase a Maytag washer, or for that matter a GE or Whirlpool, confident that they were buying a quality product. The retailer was no longer adding any value.
And so it is that today’s successful retailers offer little by way of service and their “brands” are far from imprimaturs of quality. Consider warehouse stores such as Costco and Sam’s Club. These are little more than big impersonal boxes and offer no service to speak of. But the Maytag washers sold by Costco and Sam’s Club work just as well as the Maytags sold by local appliance stores and probably come with lower price tags. The same is true for refrigerators sold by Lowe’s and Home Depot hardware stores and Sony televisions sold over the Internet. Value creation today belongs to the most prized brands and the retailers who can put branded products in customers’ hands at the lowest cost.