360 • Chapter 10 • Information and Value Creation

remains only one dimension of quality, and online customer satisfaction ratings are not immune from the many biases discussed in this chapter.

CHAPTER SUMMARY

Firms can differentiate their products and services vertically (offering additional benefits valued by all consumers) or horizontally (offering benefits valued by some but not all consumers).

Firms can inform consumers about their products benefits by disclosing quality. Alternatively, third party certifiers can disclose firm quality.

Consumers engage in search to find the products that best meet their needs. Search can be sequential or simultaneous.

Products for which consumers can readily compare alternatives prior to purchase are called search goods. Consumers may not learn the value of experience goods until after purchase.

Markets can unravel if high-quality sellers disclose their quality, leading all other firms to eventually disclose as well. When firms do not voluntarily disclose, government agencies may require them to disclose.

Firms that wish to inform consumers about their quality have alternatives to disclosure. These alternatives include warrantees and branding.

Third-party report cards can inform consumers about product quality when firms do not disclose. Report cards can be developed by independent firms and government agencies.

Firms may respond to report cards by multitasking. They improve their performance on measured dimensions of quality while cutting back on unmeasured dimensions. This is sometimes referred to as “teaching to the test.”

Quality is multidimensional and quality metrics include the value of the product in use (in healthcare this is known as outcome quality), process (how the product was made), or inputs (the qualifications of those who made it). Customer satisfaction is a widely used quality metric but has many inherent drawbacks.

Some quality metrics, such as healthcare report cards based on patient outcomes, must be risk adjusted. Otherwise, providers who take on the most difficult cases will obtain the lowest scores. Similar adjustments might be necessary for other professional services such as education.

Report card scores should be presented in a simple, easy-to-digest fashion. Composites that combine many quality dimensions into a single score can be valuable.

There are many ways that sellers can game report cards, improving their measured scores without changing actual quality or even reducing quality. Certifiers must design report cards to minimize opportunities for gaming.

Certifiers may compete against one another. Certifiers must also take care to avoid issuing biased opinions. In some markets such as financial services, biases can help certifiers to prosper.

In markets for horizontally differentiated goods, certifiers can match buyers to the sellers who best meet their idiosyncratic needs. The Internet allows sellers to obtain detailed information about consumer purchasing habits, facilitating close matching of products and customers.

Endnotes • 361

QUESTIONS

1.Can a market be vertically differentiated and horizontally differentiated at the same time? If not, why not? If so, give some examples.

2.During the 1990s, a consortium of private health insurance firms began measuring their own quality. Within a few years, many of these insurers voluntarily disclosed their quality. Why do you believe this industry moved to create quality measures? Disclosure was more common in some states than in others. Why do you believe there was such geographic variation?

3.Which of the following meet the economic definition of an informative signal?

(a)A man asks for a woman’s hand in marriage and gives her a large diamond ring.

(b)The same man takes his fiancée for a walk along the beach where he promises he will stop driving fast cars.

(c)The same woman promises her employer that she will finish an important report before the wedding date.

(d)The woman offers to accept a lower salary in exchange for a large bonus if she meets the completion deadline.

4.Advertising has been likened to offering a performance bond, where the seller must relinquish the bond if certain performance goals are not met. What is the link between advertising and bonding?

5.In the United States, most hospitals are nonprofit, but nearly all pharmaceutical firms are for-profit. Can you offer an explanation based on the consumer shopping problem?

6.When report cards are noisy, high-quality sellers can sometimes receive low rankings. Sellers complain that this is unfair. But is it necessarily bad for consumers?

7.Give examples of actions that are substitutes in production. Give examples of actions that are complements in production.

8.A former dean of the Kellogg School of Management used to warn faculty not to gloat about the school’s #1 ranking in Business Week. Why do you suppose he issued this warning?

9.How might you perform a “risk adjustment” of Consumer Reports’ automobile reliability ratings?

10. What strategies do college students employ in order to “game” their academic report cards? In light of this gaming, how can prospective employers and graduate schools determine the true academic performance of undergraduates?

11. Do teachers face a conflict of interest when “certifying” their students? What steps can schools and potential employers and graduate schools take to eliminate the problems created by these conflicts?

12. “There are huge economies of scale in the matchmaking market.” Explain.

ENDNOTES

1Much of the material in this chapter is drawn from Dranove, D., and G. Jin, “Quality Disclosure and Certification: Theory and Practice,” Journal of Economic Literature 48(4), 2010, pp. 935–963.

2The terms search good and experience good were introduced in Nelson, P., “Information and Consumer Behavior,” Journal of Political Economy, 78(2), 1970, pp. 311–329.

362 • Chapter 10 • Information and Value Creation

3Spence, A. M., “Job Market Signaling,” Quarterly Journal of Economics, 87(3), 1973, pp. 355–374.

4 This information was obtained from Daye, D., and B., Van Auken, “History of Branding,” http://www.brandingstrategyinsider.com/2006/08/history_of_bran.html, 2006. Searched December 15, 2008.

5Zhang, Y. “The Welfare Consequences of Patient Sorting,” Northwestern University Doctoral Dissertation, 2011.

6Holmstrom, B., and P. Milgrom, “Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design,” Journal of Law, Economics, and Organization, 7, 1991, pp. 24–52.

7Parts of this example are drawn from Figlio, D., and S. Loeb, “School Accountability” in Hanushek, E., Machin, S., and L. Woessmann (eds.), Handbook of the Economics of Education, Vol. 3, 2011, Holland, Netherlands, Elsevier, 2011.

8Wu, B. “Information Presentation and Firm Incentives–Evidence from the ART (Assisted Reproductive Technology) Success Rate Reports, 2012, Northwestern University Unpublished Manuscript.

9Donabedian, A., “The Quality of Medical Care,” Science, 200, 1978, pp. 856–864. 10Bollinger, B., and P. Leslie, “Calorie Posting in Chain Restaurants,” Stanford University

Working Paper, 2010.

11Resnick, P. and R. Zeckhauser, “Trust among Strangers in Internet Transactions: Empirical Analysis of eBay’s Reputation System,” in The Economics of the Internet and E-Commerce, M. Bayes (ed.), Amsterdam, Elsevier Science, 11, 2002, pp. 127–157.

12Dellarocus, C., “The Digitization of Word-of-Mouth: Promise and Challenges of Online Feedback Mechanisms,” Management Science, 49(10), 2003, pp. 1407–1424.

13Miller, N., Resnick, P., and R. Zechhauser, “Eliciting Information Feedback: The Peer-Prediction Method,” Management Science, 51(9) 2005, pp. 1359–1373.

14Simon, G., “Are Comparisons of Consumer Satisfaction Across Providers Biased by Non-Response or Casemix Differences?” Psychiatric Services, 60(1) 2009, pp. 67–73.

15For a thorough discussion of risk-adjustment methods in health care, see Iezzoni, L.,

Risk Adjustment for Measuring Healthcare Outcomes, 3rd edition, Chicago, Health Administration Press, 2003.

16Scanlon, D., Chernew, M., McLaughlin, C., and G. Solon, “The Impact of Health Plan Report Cards on Managed Care Enrollment,” Journal of Health Economics, 21(1), 2002, pp. 19–41.

17 See Brook, R., “Managed Care Is Not the Problem, Quality Is,” Journal of the American Medical Association, 278, 1998, pp. 1612–1614. This example also cites Werner, R., and

D. Asch, “The Unintended Consequences of Publicly Reporting Quality Information,” Journal of the American Medical Association, 293(10), 2005, pp. 1239–1244.

18Figlio, D., and L. Getzler, “Accountability, Ability, and Disability: Gaming the System,” in Gronberg, T., and D. Jansen (eds.), Improving School Accountability (Advances in Applied Microeconomics, Volume 14), Emerald Group Publishing Limited, 2006, pp. 35–49.

19Train, K., and C. Winston, “Vehicle Choice Behavior and the Declining Market Share of U.S. Automakers,” International Auto Review, 48(4), 2007, pp. 1469–1496.

20Michaely, R., and K. Womack, “Conflict of Interest and the Credibility of Underwriter Analyst Recommendations,” Review of Financial Studies, 12, 1999, pp. 653–686.

21Chevalier, J., and G. Ellison, “Career Concerns of Mutual Fund Managers,” Quarterly Journal of Economics, 114, 1999, pp. 389–342.

22Hubbard, T., “How Do Consumers Motivate Experts? Reputational Incentives in an Auto Repair Market,” Journal of Law and Economics, 45(2), 2002, pp. 437–468.

23Satterthwaite, M. “Consumer Information, Equilibrium Industry Price, and the Number of Sellers,” Bell Journal of Economics, 10(2), 1979, pp. 483–502.