In his review of George Akerlof’s and Robert Shiller’s Phishing for Phools, Peter Klein – a student of Oliver Williamson – suggests that
George Akerlof could walk down the hall and speak to his UC Berkeley colleague and fellow Nobel Laureate Oliver Williamson for a better understanding of how markets work. Williamson, of course, is famous for explaining how market actors protect themselves against opportunistic behavior from other market actors through contracts, joint ownership of assets, reputation, exchange of “hostages,” and similar practices. It is markets, not government, that enable cooperation and joint production in the face of information and incentive problems.
Peter’s suggestion is wise. Phishing for Phools contains virtually no recognition of the many ways that market institutions arise to protect people from the consequences of information inadequacies and asymmetries. Akerlof and Shiller are correct, as I agreed in this earlier post, that entrepreneurs will seek to profit off of consumers’ inadequate knowledge. But Akerlof and Shiller are incorrect to end their analysis with entrepreneurs exploiting consumers’ informational (and psychological) deficiencies; Akerlof and Shiller are incorrect to describe this exploitation as a “phishing equilibrium.” It’s not an equilibrium because some entrepreneurs’ successful phishing of consumers for phools – or even the prospect of consumers being phished for phools – creates profitable opportunities for other entrepreneurs to help consumers avoid being phished for phools.
Take the department store. One of its functions is to screen for, and to warrant, the quality of the merchandise that it offers to consumers. Its buyers – that is, its employees and agents who acquire for it the merchandise that it stocks – specialize in sorting unacceptable-quality from acceptable-quality merchandise and, thereby, ensuring that the store carries only the latter. Department stores that succeed in supplying this quality-assurance service have the value of their name brands tied closely to their continuing success at assuring the minimum level of merchandise-quality that their customers come to expect from them.
This quality-assurance function is performed by department stores as a profit-seeking maneuver – one that helps to protect consumers from being “phished for phools.” Yet I recall nowhere in Phishing for Phools this function of the department store being mentioned.
More broadly, brand names themselves serve to ensure quality for consumers who find it too costly directly to observe pre-purchase the quality of the goods and services that they are considering for purchase. The value of the brand name – “McDonald’s”, “Green Giant”, “BB&T”, “Honda”, “Krups”, “Liz Claiborne”, “Hilton”, “Chateau Lafite Rothschild”, “Amazon.com” – depends upon the owner of the brand name continuing to supply the minimum quality that has come to be expected from goods and services sold under that brand name. The self-interest of the owners of brand names generally impels them to continue to supply the minimum expected quality of their goods or services.
Here’s Armen Alchian in “Why Brand Names?” (a chapter in The Collected Works of Armen A. Alchian (2006), Volume 1 [“Choice and Cost Under Uncertainty”*]):
What sources of information can he [the consumer] rely on? Aside from personal knowledge (very expensive) and the explicit warranty, he can rely on the reputation of the supplier, a reputation based on past performance – a performance he projects into the future. In other words, if a customer can predict that the supplier will continue to perform in the future as he has in the past, he will use the past performance as information. The reputation of the supplier is based on past continued performance. The supplier is identified by his name. His name is his brand name, his trademark.
Another, related market institution that helps to assure minimum expected product quality is advertising. Advertising is not only a means by which firm A can inform the public of its offerings and prices. Advertising also enables firm A to inform the public of firm B’s unexpectedly poor quality or excessively high prices – and the very possibility of such information being spread by firm A through advertising makes firm B less likely to try to phish consumers for phools.
Perhaps even more importantly (as argued in a justly celebrated 1981 paper by Ben Klein and Keith Leffler), successful advertising enables firms to sell products at prices above marginal costs of production. This price premium obviously is valuable to firms. But this premium will last only if consumers judge the ‘high’ price to be worth the better quality that is promised by the advertising. Here’s Klein writing in David Henderson’s Concise Encyclopedia (original link):
Consumer reliance on brand names gives companies the incentive to supply high-quality products because they can take advantage of superior past performance to charge higher prices. Benjamin Klein and Keith Leffler (1981) showed that this price premium paid for brand-name products facilitates market exchange. A company that creates an established brand for which it can charge higher prices knows that if it supplies poor products and its future demand declines, it will lose the stream of income from the future price premium it would otherwise have earned on its sales. This decrease in future income amounts to a depreciation in the market value of the company’s brand-name. A company’s brand-name capital, therefore, is a form of collateral that ensures company performance. Companies without valuable brand names that are not earning price premiums on their products, on the other hand, have less to lose when they supply low-quality products and their demand falls. Therefore, while consumers may receive a direct benefit for the extra price they pay for brand-name products, such as the status of driving a BMW, the higher price also creates market incentives for companies with valuable brand names to maintain and improve product quality because they have something to lose if they perform poorly.
Ironically, many of the market institutions that serve to assure product quality – that serve to protect consumers from being phished for phools – are institutions much derided by most of the people who likely find Akerlof’s and Shiller’s book to be an accurate and sobering description of market realities. Such people do not understand brand names, and so they assume that brand names are a devious way of duping consumers rather than a market institution that protects consumers. Ditto for such people’s assessment of advertising and of large-scale retailing by department stores and supermarkets.
(Yet another market institution that helps to protect consumers from being phished for phools is credit cards. Akerlof and Shiller discuss credit cards in their book, but only as a device that allegedly causes consumers to spend more money than consumers ‘really’ want to spend. Whatever the merits of that argument – which I’ll not address here – credit cards also often allow consumers to avoid paying for poor-quality goods and services. For example, if the product you bought on-line isn’t what its seller promised, you can call your credit-card issuer and complain. The issuer will often investigate and, if it determines that you’ve been defrauded, will not require you to pay and will demand redress from the merchant. If the merchant refuses, the credit-card issuer removes that merchant from its network so that that merchant can no longer receive payment from customers using that credit card. Nowhere in their book do Akerlof and Shiller mention this quality-assuring market institution.)
It’s understandable that non-economists are unfamiliar with the works of economists such as Oliver Williamson, Ben Klein, Keith Leffler, Armen Alchian, Harold Demsetz, Israel Kirzner, Yale Brozen, Lester Telser, and my dissertation advisor Bob Ekelund. But it’s disappointing that economists – Nobel laureate economists, no less – write as if they are unaware of the works of economists such as these. (UPDATE: As Tim Worstall reminds us, Akerlof and Shiller write as if they are unaware even of Akerlof’s own, most-famous article, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” Surprisingly, this 1970 article doesn’t appear in the book’s long Bibliography. It is not mentioned in the book’s text, and I do not recall seeing it mentioned in the book’s many, often longish footnotes.)
Akerlof and Shiller might disagree with the analyses and conclusions – both theoretical and policy – of such economists. But these economists and their works are so prominent and widely respected that for Akerlof and Shiller not to as much as mention such researches in their book makes it appear as if Akerlof and Shiller are trying to phish their readers for phools into accepting their argument for market failure – an argument that largely ignores the role of market institutions and the voluminous scholarly research into those institutions.
Far closer to the truth than are Akerlof and Shiller is Thomas Sowell, who writes on page 184 of the 5th (2015) edition of his Basic Economics that
The great financial success stories in American industry have often involved companies almost fanatical about maintaining the reputation of their products, even when these products have been quite mundane and inexpensive.
…..
* Note the very title of this volume of Alchian’s collected works.
