It's Good to be Bad

This paper starts with a simple question: Why do some firms tell consumers that they are low quality? That may seem a strange question but if you look at some advertising that is around that certainly seems to be part of the message they are trying to communicate. Take Ryanair for example, a self proclaimed "no frills" airline. Ryanair regularly communicates that they are low quality through the way they approach the media. As an example in 2011 they publicly floated the idea of charging for toilet use on a plane. Their CEO has also made many statements to the media suggesting low quality like when he said "Anyone who thinks Ryanair flights are some sort of bastion of sanctity where you can contemplate your navel is wrong. We already bombard you with as many in-flight announcements and trolleys as we can. Anyone who looks like sleeping, we wake them up to sell them things."

Looking at the market for lawyers in America reveals a similar story. There are no less than 3 American lawyers who call themselves "the hammer". In Texas there is a lawyer named Bryan Wilson who advertises by calling himself the "Texas Law Hawk", riding jetskis and throwing sticks of dynamite in his commercials. This kind of advertising is strongly discouraged by the American Bar Association who warn that "lawyers should consider that the use of inappropriately dramatic music, unseemly slogans, hawkish spokespersons, premium offers, slapstick routines or outlandish settings in advertising does not instill confidence in the lawyer or the legal profession".

It certainly seems that these firms want to communicate that they low quality to the market or at the very least they are unconcerned with being perceived that way. Why would a firm want to disclose their low quality however? One potential explanation is that maybe this kind of advertising gets free media coverage. If this coverage meant that many consumers knew about the firm but judged it to be low quality however then it is not clear the firm would be better off.

This paper presents a different explanation in a consumer search model. Consumer search theory is an area of economic theory & industrial organisation where it is possible to get really counterintuitive results. This is great from one perspective as counterintuitive results can be quite interesting. It also means however that it can be difficult to explain a result without resorting to a mathematical model. For this reason I have to use a little bit of maths in what follows to make it make sense.

Consider a market where there is a low quality firm and a high quality firm each of which makes a good costlessly. The consumers are a diverse bunch with some that are are willing to pay alot to get better quality ("high taste consumers") while some others are nearly indifferent and would not pay much to upgrade from the low quality good to the higher quality good ("low taste consumers") [1]. Now consider that every day every consumer walks to one of the firms. Each firm now needs to determine a price to offer all of the consumers that approach them. The consumers can accept that price and buy the good; walk to the other firm with a search cost (or bootleather cost) of $1 or go home and get a utility [2] worth $0.

So what price should a firm choose to charge? One thing that a profit maximising price must satisfy is that one of the consumers should be just about indifferent to buying and taking their outside option (of either walking to the other firm or going home). If this were not the case then the firm could increase their price and get a higher margin without losing any consumers because noone is close to being indifferent [3]. This is the key aspect of the firm's pricing decision that we will use to figure out what happens in this market.

Let's look at the problem for the high firm. Lets say they choose a midtaste consumer to be indifferent. This means the firm would like to sell to this consumer and all of the consumers with a higher taste than her. Now to determine the price that the high firm should charge this consumer. This is largely determined by the outside option of walking to the other firm to buy there. She anticipates that she can get a utility of $5 if she bought the low firm good (after paying the low firm's price). Let us also say that she values the high good at $10. We can now work out that her outside option[4] is worth $4 and so to be made indifferent the firm will charge her(and everyone with a higher taste) $6 which will give her a utility of $4. Now consider what happens the next day. She can anticipate that if she goes to the high firm again she will end up with a utility of $4. If she goes to the low firm initially however she will end up with a utility of $5. So she will go to the low firm initially.

Now they have lost her the high firm wants to make a slightly higher taste consumer indifferent to maximise their profit. Lets consider the case of this new consumer to be made in different. This consumer anticipates that he can get a utility of $5 from buying from the low firm (after paying the low firm's price) and values the high good at $11. He also faces the same $1 search cost. Now his outside option is worth $4, the high firm should charge him a price of $7 to make him indifferent and he will end up with a utility worth $4. Now consider what happens the next day. He can anticipate that if he goes to the high firm again he will end up with utility worth $4 . If he goes to the low firm initially however he will have ended up with a utility of $5. It is again better to go to the low firm initially.

Now it should be clear that there is some unravelling going on. Every day the low firm manages to peel off those high firms consumers that care the least about quality. This will continue until the high firm has no consumers left. The low quality firm will achieve market domination. Note that a key thing that is necessary for this to work is that consumers choose what firm to approach when they enter the market. If consumers did not know the quality of the two firms then this mechanism would not work and the high quality firm would be able to keep a decent amount of consumers. Thus this unravelling result can have the effect of encouraging low quality firms to disclose their low quality and this disclosure can drive the high quality firm out of the market.

Another key element is that a firm cannot promise to set a particular price before consumers visit the firm. If firms could commit to a certain fixed price then the unravelling could not continue. A key element of the unravelling is that every time the high firm loses a consumer who cares about quality relatively little, they increase their price because their remaining consumers care more about quality. If a price could be committed to then this could not continue. This means that clearly this model is not appropriate for markets where prices are set and posted, however it would be appropriate for other markets where prices are generally unknown or set after a consumer visits a firm [5].

The policy implication of this paper is that the market can be made more efficient by banning low quality firms from advertising or communicating to the market. This is a problematic implication as it could be argued that consumers and firms have a moral right to free communication before entering into a transaction. Nonetheless there may be some cases where it is feasible and desirable to ban low quality disclosure. The best example that I know of is the American market for lawyers where the American Bar Association (ABA) banned all lawyers from advertising from 1907 until 1977 (when the Supreme court overturned that advertising ban on freedom of speech grounds). This paper implies that by allowing advertising the market is lead to a state where low quality lawyers get a large amount of business with negative impacts on consumers and high quality lawyers. Thus this paper suggests an additional reason in support of the ABA's argument lawyers should not advertise.


[1] You can think of the market for flights: everyone prefers more legroom to less legroom but very tall people care alot and very short people don't care very much.

[2] Utility is the measure economists use for wellbeing. You can think about it as being like profit: As firms maximise profit so do consumers maximise their utility.

[3] By contrast if a consumer is about indifferent to buying the good than a price increase could tip them to prefer their outside option and the firm would lose this consumer.

[4] because she needs to pay the $1 search cost to walk to the other firm.

[5] Flights and legal fees seem good examples of this kind of pricing.