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TOPIC 5: QUALITY AND MANAGEMENT (ideas from contracting firms +others)
0) Scenario:
When apple sells this laptop, you BELIEVE what this computer has (reading the description they give to you), you DON’T KNOW if all that is said is true or false.
1) Quality and associated problems:
• QUALITY (two definitions):
• The product has a very high value (not in this topic) –National geographic has good
quality and the big brother don’t-.
• Simply characteristic of a good (color, taste, durability, price, etc.). Each good has
many attributes.
Would you rather use a postal service that always delivered letters in four days or sometimes in two days and sometimes in six? – no, because i won’t never know when to send the letter. Would you find it more difficult to have a friend who always arrived 30 minutes late or sometimes on time and sometimes an hour late? – more difficult the one that you can’t predict.
What are the implications for quality? – it has to be always the same. Predictable, i need to know how the good will be.
STANDARDIZATION: providing a good with a known fix quality.
• The major goal of firms is to provide goods of standard quality. A Firm is good at
managing quality when manages to provide standardized products to customers.
• In this sense a company like McDonald’s can claim to manage quality well.
• Managing quality well is ultimately about increasing profits, many firms place a huge
emphasis on it (TQM).
How can companies achieve this? – 3 challenges.
1- Define quality F 0 E 0market research. Design the product, the marketing strategies…
“What are you going to sell?”
2- Control quality in a technical sense F 0 E 0monitor both the performance of the factory and
customer satisfaction. “Put in place the systems to produce this products”
3- Safeguard quality F 0 E 0actually provide the quality level that customers expect to buy.
“how to make that the product you produce is equal to consumer’s belief they are buying”
Failures to provide quality:
• Perrier: traces of benzene. Pills supposed to cure killed people.
• Tylenol: traces of cyanide.
• Dasani: purified tap water in UK. Water consumers expected to buy “puresa natural” but
it actually was filtred tap water. (the expectations didn’t fit the product)
• Toyota: faulty accelerator pedals. Middle cass, safe, functional, that were some Toyota’s
attributes until the faulty accelerator pedals. They didn’t provide what they said to be doing.
How can companies avoid this?? F 0 E 0 Safeguarding quality.
The problem of safeguarding quality depends on the kind of good in question. A key distinction is whether consumers can observe quality before buying or not.
TYPE OF GOOD
DEFINITION + TYPICAL PROBLEMS EXAMPLES
SEARCH Products whose quality can be verified before purchase
- To lower information cost for customers
Bank accounts, financial products EXPERIENCE Products whose quality is learned after consumption.
- How to convince customers that the quality is the promised one.
Restaurant dinner, haircut
CREDENCE Good whose quality is not observable even after consuming. It may be observable only in the long-run or even never.
- a very serious problem of convincing customers of level of quality.
Surgical operations, car repairs.
Every good has different attributes but one is the main one. In fact it might make more sense to think about search, experience, and credence attributes rather than goods. For example, price is always observable, a good’s durability is almost never.
2) One time trade with unobservable quality (Safeguarding one-shot
transactions) Consider a situation in which a buyer and a seller interact once in a market. The buyer of a good does not know its value but the seller does.
What was the problem here? –Adverse selection. A high value good is not traded because of preference of low value good. If customer could know which one is the best good (the one with better quality) he would choose it. What did we say the solutions were?
• Signaling
• Screening
• Give verifiable information
• Companies get the information and sell it.
Interesting fact: the mere fact of purchasing a new car reduces its value 10%. A car has some experience attributes, it means that we won’t know them until we have used it. If once we have used it we want to sell the car again, that means that something in the car hasn’t liked us. It means that something didn’t fit our expectations, and, in consequence the future consumers’.
a) PRIVATE SOLUTION I: eliminate the information asymmetry.
For example, used cars are often sold among friends, and these are higher quality than the average used car. Also, sellers often let prospective customers examine products, for example car “test –drivers”
b) PRIVATE SOLUTION II: information asymmetry may in fact be a market
“opportunity” for firms to provide value. Companies like rating agencies in financial markets and Consumer Reports make money by gathering and selling information. (an information market) Suppose there’s a company specialized in gathering all the information for you (customer), you don’t have to do it. It’s easier for them because ……?
Example: The latin American taxi market is very large (3.8 bilion taxi rides per year). There are serious information asymmetries: overcharging is commo; robbery is not infrequent; kidnapping is reported…
Business Opportunity: in 2011, Clemens Raemy started SaferTaxi , and company aimed at the taxi markets in São Paulo, Buenos Aires and Santiago. Accompany that collected info that overcomes this lack of information. Customers use a mobile application to order a cab and select the best rated drivers. The ratings come from the customers themselves.
• Key question: where does the cost of bad behavior come from? –if painter
misbehaves it won’t have job any more with that customer. The painter might behave today in order to keep being able to paint tomorrow.
• What if you hired a painter and he did not do a good job?
• What would be your incentives to hire him in the future?
We still have to think about how to create the economic incentives for this: The painter’s additional effort must be rewarded with a high price. In the previous example suppose p = 75
• INCENTIVES (economic incentives): the additional effort to behave must be rewarded
with a high price.
Remember the example: Painter: “I don’t want to come tomorrow” There is no time horizon, no incentives for the painter to behave properly. I’ll have to give him some part of my surplus (pay him more). Painter will only work for you if the price is bigger than 50 (the cost of working hard)
P=50 F 0 E 0no profit for the painter, he wants more surplus to behave well. “I want client’s extra surplus”
P=75 F 0 E 0
Quality Client Gain
Painter Gain
Surplus
Good (100-p) 25
(p-50) 25 50
Bad (60-p)
-
(p-45) 30 15
There’s always the temptation for painter to cheat today. (He gains more misbehaving), so we need to reduce cost by 5 (50-45). What will be the gain from behaving -if you work well today, there will be more trades tomorrow. If the client hires you again tomorrow you’ll get 25 more units of surplus everyday. No matter the painter does today, he gets the same price, but if he plays well he will be hired again earning 25 more units every time.
• QUASI RENTS:
We can interpret the last situation in terms of quasi-rents. Working hard continues the relationship, generating a surplus of 50 each period. The painter’s share of this surplus is 25 each period. (Make the future payoff as big as possible and he will want to stay, so he will behave) The creation of these quasi-rents is the incentive for the painter to invest. The bigger they are, the more incentives there are.
Apple 3.000 euros for a computer: they set a high price, that’s an incentive for Apple to don’t misbehave to go on in the relationship. If they sell at 1.000, quality must be affected (cheat) and some people will stop buying and apple will have losses.
• REPUTATION:
The client does not observe the quality before contracting the painter; she is willing to contract the painter as long as she believes he will do a good job. This belief is the painters reputation : belief (expectation) you have about what action the seller is taking / of some good’s quality before having used them. If he ever does a bad job (if he cheat), his reputation is destroyed, and he does not work anymore, no more trades.
Incentive: behave well to not loose reputation.
1- Consumer has a belief about the quality, so they are willing to trade (customer and
seller)
2- Because the consumer is willing to trade, if quality is high, seller is willing to provide
high quality. If he don’t provide high quality (what customer expects), seller will lose money in future from bad behavior. They won’t trade again.
3- Belief is correct or incorrect. Depends on if the good provided fits on the consumer’s
belief.
This customer belief is the reason you have this trade, the reason to the seller behave well. In this case the contract would be: I believe you’re going to behave. That’s the reason I’m behaving.
• PROBLEM OF HORIZON:
So far we said the relationship continues, But suppose one day it comes to an end.
• What will the painter do the last period? Painter will misbehave, there’s no future, and
there aren’t gains from being contracted.
• What will he do the next to last period? – There are two options, trade with him at low
cost or don’t trade. It happens the same day before day.
The two big problems in sustaining trade in the repeated moral hazard environment are:
• (1) Dealing with the last period problem
• (2) Making sure the seller has a lot to lose from destroying future trades (é
quasi-rents)
How can make seller never die? Some solutions are:
• Don’t specify time horizon:
Leaving open the nature of the relationship can help solve the last period problem F 0 E 0a more incomplete contract might be better!
• Sell to many people; Making the seller never die:
Another deeper solution is the development of “community reputation”. If you cheat one person, then everyone observes this and nobody will contract you. This is true in the online environments above. Also evidence that it helped sustain trade in the early middle ages. If you sell to different people maybe jut one won’t like your product.
• Community reputation makes the buyer “live forever” if the community never dies
• It also significantly increases the loss from cheating a single customer
• Finally, it also helps overcome the severe information problems in the credence good
case
But:
• The community reputation idea does not solve the problem of the seller having a finite
horizon
• All of us must retire some day, even if it’s on the day we die
Giving the product for free during a period and let the consumer know the quality it has. Then the consumer gets used and wants to pay for it. Why does La Vanguardia occasionally give away newspapers for free here at UPF?
• Stretch reputation:
Companies with previously established reputation can establish new products. Providing poor quality in these new products would damage the existing products, so they have good reputation to have good quality.
The new products should provide a similar quality level as the old ones, why? To maintain their reputation. If they produce in less quality, their reputation goes away. They want to maintain the quality of their products, producing always in the same quality to go on with their image.
• Brand Stretching: When a name alone is enough to create reputation.
Example: Dior and Armani. They started in very expensive fashionable clothes, with good quality. They convinced the world about it. Then Dior started to produce jewellery, why he should do good jewellery? His brand said this. He wouldn’t produce something that could damage his image.
• Creating new Brands: if you want to produce in a different quality of your
original brand (the one that already has reptutation) you create a new one. If they want to create a different image. Example: Armani Exchange is a brand of Armani but that produces in a less quality. He created a different brand to not damage the original one.
• How to get in a market with no reputation before?:
Many new companies sell their products through established retailers (rely on their reputation). These retailers have their own reputations to maintain (e.g. El Corte Inglés). If they sell low quality products, their reputations suffer. Retailers can themselves engage in “brand stretching” by selling their own products (e.g. Hacendado)
• Advertising:
Advertising is a controversial subject in economics. Does it have any role for “rational” consumers? In the context of search goods, it can act to deliver information; this is called “informative” advertising. But is this really what ads do?
• Informative ads:
• Is there information in the more quality goods ones? –No, they are more creative
denoting more money invested, so more quality of the product.
Increase utility of consumers from consuming products F 0 E 0but then why don’t people watch ads for fun?
• Generator of quasi-rents:
When a firm advertises, one could argue that it is implicitly telling consumers that its product is high quality Why would firms spend a lot of money advertising a product that they then were planning to use to deceive consumers?
• Credible signaling:
A related idea is that of advertising as a signal of quality. Here the difference is not on the cost side, but on the benefit side. In a repeated sales context, consumers might be fooled once but not twice. Not for difference in price, but difference in benefits.
Ex: Suppose a firm can purchase an ad for 60 prior to a consumer deciding whether to purchase the good in each of two periods. The price of the good is fixed at 50. At this price, the consumer is willing to purchase a high quality good but not a low quality good:
• Ads cost 60 for all firms (opp cost)= 40
• Payoffs for high q. firm: -60 + 50 (p1) + 50 (p2) +…+ 50(pn) = 40 + (future
purchases)
• Payoffs for low quality firms = -60 + 50(p1) + 0 (future purchases) = -
Suppose a high quality seller advertises and a low quality seller does not. The payoff for the high quality seller is 100 – 60 = 40, and the payoff for the low quality seller is 0. If the high quality seller did not advertise, it would get 0 and if the low quality seller advertised it would get 50 – 60 = -
• Money burning (implies they have money to burn):
Arguments of this kind can rationalize not just advertising, but all kinds of seemingly wasteful expenditures. High quality providers “burn money” to convince other people that their products or services or good:
• Investment bank client functions
• Expensive art or office furniture
5) Explicit Contracting solutions:
Up until now we have focused on implicit guarantees based on reputation. But there are many examples of more formal contracts in markets: If you buy my product and you don’t like….
5)..i Free exchange of products
5)..ii Money-back guarantees
5)..iii Promise to repair faults
They ensure you won’t have risk when you buy their product.
• Enforcement:
Unclear whether such agreements have any legal value, either because judge cannot verify quality or because litigation is too costly for a small complaint. So what makes companies follow through on their explicit contracts?
• Maybe they can’t go to courts but if they fail, customers won’t come back.
• Implicit contract (reputation) underlies the enforcement of explicit contracts.
• Information problems:
Like all contracts, these contracts will potentially have moral hazard and adverse selection problems
• Adverse selection: if a product comes with a full guarantee, clients that are more
likely to use it buy it
• Moral hazard: abuse product F 0 E 0what would happen if you could return DVDs, CDs,
and books? –Abuse.
• Efficient structure of Guarantees
Guarantee products that clients don’t have a clear incentive to abuse (laptop).
• Limit duration of guarantee. If not, Moral Hazard.
• Rule out defects arising from inappropriate use ◊ but how to tell? – you can’t observe
tha actions on the agent.
• Guarantees as signals:
Guarantees can also act to separate good from bad quality products: They are costly and have a cost differential. They communicate high quality. Firms won’t sell you a bad quality thing with guarantee, they’d loose money.
Example: Suppose high quality goods are worth 100 to consumer and never break down.
• Suppose low quality goods are worth 20 to consumer and breakdown with some
positive probability.
