1

Business Economics I

Quality Assurance in Commercial Relations II

2

Quality assurance in non-repetitive transactions I

The causes of the problems with quality assurance: Asymmetric information

The problem of second hand cars: Cars lose 10% of their value upon registration Numerical illustration

High quality = €30 000 Low quality = € 10 000 Proportions = 50%-50%

3

Quality assurance in non-repetitive transactions II

How to solve the problem: By producing information

Three solutions in the market: Contract between informed parties: many used cars are

sold among friends; i.e. there is information how the car has been used

Examination of the car (Verification of quality) The seller offers a guarantee (dealers usually offer

guarantee covering the repairs)

4

Quality assurance in repeated transactions I

Repetition and implicit contracts Contracts that can not be enforced in court Repetition as a safeguard: future contracts vs.

opportunism today Quasi-rents as a safeguard for quality

Price should be greater than the marginal or the opportunity cost

The expected value of the quasi-rent should be sufficient to discourage non-compliance.

5

Quality assurance in repeated transactions II

The efficiency of the quasi-rents depends on 1) their amount and 2) the time horizon over which the seller expects to receive them

Why is the time horizon of utmost importance? How big the difference between price and opportunity

cost could be? And what about competition? What does long time horizon do for the total amount of

quasi-rents? Net present value – an euro today is worth more than a

euro tomorrow (discount rate)

6

Quality assurance in repeated transactions III

Repeated transaction when the parties are the same: Knowledge of prior conduct of the seller, Problems arising from a “tit-for-tat” strategy

The last period problem: What would a rational agent do if there is a finite

number of transactions (i.e.; he knows that after 1000 transaction there will be no further sales because the customer, for example, will retire and move to live somewhere else?)

7

Solving the last period problem

Making the contract of indefinite duration Don´t say when the last period is (labour contracts).

Repercussions of contracting with third parties If I sell to other persons in the region and they know

how I treat you: reputation. This means that the seller has to stay in the market for a long time

Modifying the time horizon Individuals have finite lives. Companies can live

forever

8

Repeated transactions: one seller & different customers

How often Ford sells a car to the same person? How do you safeguard quality in such a case? Producing information about quality provided in past

transactions and circulating it amongst the potential contracting parties. This information is the basis of commercial reputation – one of the

most important assets in economic activity. Efficiency of the information: clearly identifiable product or

service. That´s why brands and names are important and protected. How the information is produced and transmitted also matters.

9

Problems related to the production and transmission of reputational information I

What does happen in a restaurant or in El Corte Ingles if a customer sets up a scandal complaining that the food has been bad or the product bought has been with defect?

Reputation is a valuable asset. However, it is subject to destruction and/or expropriation: http://www.walmartsucks.com/ Is this true? MacDonald´s coffee and hamburgers contain ...

10

Problems related to the production and transmission of reputational information II

Punishment of defamation Limits of the opportunistic behavior: people who produce

and transmit information have their own reputation as informers. If they abuse or complain too often, they lose it and no one will ever believe them even if they say the truth some day in the future.

Implication: everyone has reputation at stake and this limits opportunism.

Groups are efficient: better in evaluating and publicizing. Example:Lawyers undermining the credibility of witnesses

11

Problems related to the production and transmission of reputational information III

Risk for reputational guarantees due to the misuse or incorrect functioning of institutional mechanisms: Going to court: The citizen X against MacDonald´s. A

lose-lose game for the corporation. Frivolous complaints. The mass media – informing about the pros and the

cons? – the Super Account of Banco Santander

12

Strategies to create quality-safeguarding incentives

There are two types of strategies: Low and High cost.

All strategies involve quasi-rents. Examples:

Specific assets: investment would have been sub-optimal in the absence of the safeguarding value of the asset

Uninformative advertising: resources are employed only for the purpose to generate quasi-rents.

13

Low-cost strategies I

Introductory pricing: introduce the product at a price below the corresponding quality. Keep in mind that it is the price/quality ratio that matters and that the issue is to surpass the expectations of the customers.

Specific assets: Why could they be a safeguard? The New Headquarters of Time Warner AOL: $ 1 bln Brands, signs, molds, etc.

14

Low-cost strategies II

Brand-stretching: Armani perfumes, leather belts Implication: the quality of the new product should be in

line with the quality of the original one (Levi Strauss and high-quality suits)

How would you explain the safeguarding role of brand-stretching?

Distributors as producers of safeguards El Corte Ingles, Sears. Why can distributors provide safeguards effectively

and efficiently?

15

High-cost strategies I

Advertising Are consumers irrational to be influenced by brand-

creating/uninformative advertisements? What happens with the investment in advertising if the

seller misbehaves? Perrier Volvo

And if the seller acts in good faith Tylenol

16

High-cost strategies II

The Economic view on Advertising and Differentiation: Reduction of competition BUT… Informational role + adapting to demand. Hence both

encourage competition. What do you think is the role of brands (advertising &

differentiation). Think that we live in a world full of transaction costs.

17

High-cost strategies III

Barriers to entry Law; medicine What is the intuition: ensuring that all market

participants are at least of some predetermined minimum quality.

Disadvantages: Price increases Innovation hindered Rent seeking

18

High-cost strategies IV – The role of Regulation

Regulation as a protector of reputation Objective: proportion between defaulting behaviour

and reputational sanction Definition of Quality standards

Minimum standards needed for explicit safeguarding mechanisms (especially for civil liability)

Consider the relative importance of the implicit vs. the explicit safeguards.

Have in mind that the market judges on results, not on compliance with standards.

19

High-cost strategies IV – Regulation II

Production of information Forcing the disclosure of information Being a depository and verifier of sensitive information

Examples: Labels content Statistical data related to compliance with the

legislation, which, if publicly available, would affect market competition.

20

Explicit Quality Guarantees I

How do they function: explicitly (courts) or implicitly (reputation)?

Problems arising with guarantees: Adverse selection:

Customers who plan to use heavily the products tend to buy products with more inclusive explicit guarantee

Moral hazard: Having a product with an explicit guarantee offers little

incentive for careful use

21

Explicit Quality Guarantees II

Efficient structure of the guarantees Exclusion of faults due to improper use and use of

domestic appliances for commercial use. Time or physical limit (2 years for washing machines;

50 000 km. for cars): solving for adverse selection Exclusion of liability in case of indirect damage (my

camera stops functioning after my X-sport canoe went underwater, for example): moral hazard

22

Quasi-Rents

Quasi-rent is the difference between the remuneration for a productive resource in its current use and the maximum remuneration, which would be received for its best alternative use.

In other words, a quasi-rent is how much one would use if the current relation terminates and the resource have to be employed in the best alternative use.

Example: What would happen to Starbucks Café if they start selling poor

quality coffee?

23

Expected value of Quasi-rents

The effectiveness of the quasi-rents depends on: Their amount (i.e.; the difference between price and opportunity

cost) The time scale over which they are expected to continue being

generated (the longer the time period the greater the effectiveness)

Illustration: A coffee at a standard café sell for about € 1; It sells for € 2.50 at

Starbucks Starbuck expects selling you coffee for the rest of your life (60

years more X 1 coffee per week). A person who sells you coffee at the Forum de las Culturas expects to sell you the coffee only during the forum.

24

The last period problem

Intuition: If I now that our relation is over after 1000 sales, I have

no incentive to provide the quality promised in the 1000th sale. The customer, however, is rational too and anticipates this – he does not contract me for the period 1000.

Then, the last period is the 999th one. I am rational and I know that you will not contract me in the period 1000, so I will default on the 999th one.

You will anticipate this and not contract me for the 999th period and so on till the 1st period