The Advantage

The advantage of letting people know that you have been, and are planning to be, in business a long time is that it informs them that you have something to lose –potential future business -- if you engage in dishonest dealing.  In effect, you are providing poten­tial customers with a hostage, something of value that one party to a contract (the customer) can destroy if the other party (seller) does not keep its promises. There are numerous other ways that businesses create arrangements to provide hostages in ways that make their commitments to honest dealing credible.  Before examining some of these arrangements, however, it is important to consider an important feature that hostages should have.

The use of hostages has a long history, and is traditionally thought of as a way to reduce the likelihood of hostilities between two countries or kingdoms.  For example, if King A intended to wage war on Kingdom C and wanted to keep Kingdom B neutral, he could assure King B of his good faith by yielding up his beloved daughter to King B as a hostage. Assuming King A really did love his daughter, he would then be very reluctant to break his promise and invade Kingdom B after conquering Kingdom C. But even if King A does have a compelling incentive not to wage war against King B as long as his daughter is King B’s hostage, a potential problem remains.  King B may find the daughter so attractive that he values her more than her father’s promise not to invade.  Therefore, King B may decide to join with Kingdom C against King A and keep the daughter for himself. This suggests that an ugly daughter (one only a father could love!) makes a better hostage than a beautiful daughter.

A firm’s reputation can be thought of as a hostage that the firm puts in the hands of its customers as assurance that it is committed to honest dealing. A firm’s reputation is an ideal hostage because it is valuable to the firm, but has no value to customers apart from its ability to ensure honesty.  A firm has a motivation to remain honest in order to prevent its reputation from being destroyed by customer dissatisfaction, but customers cannot capture the value of the reputation for themselves. The more a firm can show that it values its reputation, the better hostage it makes.

Consider the value of a logo to a firm. Companies commonly spend what seems an enormous amount of money for logos to identify them to the public.  Well-known artists are paid handsomely to produce designs that do not seem any more attractive than those that could be rendered by lesser-known artists (many of whose artistic efforts have never gone beyond bathroom walls).  Furthermore, companies are seldom shy about publicizing the high costs of their logos.

It may seem wasteful for a company to spend so much for a logo, and silly to let consumers know about the waste (the cost of which ends up in the price of its products).  But expensive logos make sense when we recognize that much of the value of a com­pany’s logo depends on its cost. The more expensive a company’s logo, the more that company has to lose if it engages in business practices that harm its reputation with consumers, a reputation embodied in the company logo.  The company that spends a lot on its logo is effectively giving consumers a hostage that is very valuable to the company. Consumers have no interest in the logo except as an indication of the company’s commit­ment to honest dealing, but will not hesitate to destroy the value of the logo (hostage) if the company fails to live up to that commitment.

Expensive logos are an example of how businesses make non-salvageable investments to penalize themselves if they engage in dishonest dealing.  Such investments are particularly common when the quality of the product is difficult for consumers to determine. The products sold in jewelry stores, for example, can vary tremendously and few consumers can judge that value themselves.  Those jewelry stores that carry the more expensive products want to be convincing when they tell customers that those products are worth the prices being charged.  One way of doing this is by selling jewelry in stores with expensive fixtures that would be difficult to use in other locations: ornate chandeliers, unusually shaped display cases, expensive counter tops, and generous floor space. What could the store do with this stuff if it went out of business?  Not much, and this tells the customers that the store has a lot to lose by misrepresenting. The idea of firms intentionally making their profits vulnerable to the actions of others may seem inconsistent with our discussion on “make-or-buy” decisions.  In that early chapter we argued that firms often forgo the advantages of buying inputs in the marketplace by making them in-house to protect their profits on their investment against exploitation by others. The difference in the two cases is important.  When firms put their profits at risk as a hostage to consumers, those consumers cannot capture the profits for themselves. They can only destroy them, and their only motivation for doing so would be that the firm is no longer satisfying their demands. In the case where a firm incurs the disadvantage of producing in-house to protect its profits, the problem is that suppliers can actually capture those profits for themselves by acting opportunistically, or dishonestly. So in some cases protecting profits promotes honest dealing, and in other cases putting those profits at risk promotes honest dealing.  
The importance business people attach to committing themselves to honesty sometimes leads them to put their profits in a position to be competed away by other firms that will benefit from doing so.  Consider a situation where a firm has a patent on a high quality product that consumers would like to purchase at the advertised price, but a product that would be difficult to stop using because its use requires costly commitments.  The fear of the potential buyers is that the seller will exploit the long-term patent 

Consider the value of a logo to a firm. Companies commonly spend what seems an enormous amount of money for logos to identify them to the public.  Well-known artists are paid handsomely to produce designs that do not seem any more attractive than those that could be rendered by lesser-known artists (many of whose artistic efforts have never gone beyond bathroom walls).  Furthermore, companies are seldom shy about publicizing the high costs of their logos.  

It may seem wasteful for a company to spend so much for a logo, and silly to let consumers know about the waste (the cost of which ends up in the price of its products).  But expensive logos make sense when we recognize that much of the value of a com¬pany’s logo depends on its cost. The more expensive a company’s logo, the more that company has to lose if it engages in business practices that harm its reputation with consumers, a reputation embodied in the company logo.  The company that spends a lot on its logo is effectively giving consumers a hostage that is very valuable to the company. Consumers have no interest in the logo except as an indication of the company’s commit¬ment to honest dealing, but will not hesitate to destroy the value of the logo (hostage) if the company fails to live up to that commitment. 

Expensive logos are an example of how businesses make non-salvageable investments to penalize themselves if they engage in dishonest dealing.  Such investments are particularly common when the quality of the product is difficult for consumers to determine. The products sold in jewelry stores, for example, can vary tremendously and few consumers can judge that value themselves.  Those jewelry stores that carry the more expensive products want to be convincing when they tell customers that those products are worth the prices being charged.  One way of doing this is by selling jewelry in stores with expensive fixtures that would be difficult to use in other locations: ornate chandeliers, unusually shaped display cases, expensive counter tops, and generous floor space. What could the store do with this stuff if it went out of business?  Not much, and this tells the customers that the store has a lot to lose by misrepresenting.

Another possibility is for the seller to give up his or her monopoly position by licensing another firm to sell the product.  By doing so the seller makes his or her promise to charge a reasonable price in the future credible, since if the seller breaks the promise the buyer can turn to an alternative seller.  Giving up a monopoly position is a costly move of course, but it is exactly what semiconductor firms that have developed patented chips have done. To make credible their promise of a reliable and competitively priced supply of a new proprietary chip (the use of which requires costly commitments by the user), semiconductor firms have licensed such chips to competitive firms.  Such a licensing arrangement is another example of making profits by way of a hostage intended to encourage honesty.7 

The more difficult it is for consumers to determine the quality of a product or service, the more advantage there is in committing to honesty with hostage arrangements.  Consider the case of repair work.  When someone purchases repair work on their car, for example, they can generally tell if the work eliminates the problem.  The car is running again, the rattle is gone, the front wheels now turn in the same direction as the steering wheel, etc. But few people know if the repair shop charged them for only the repairs necessary, or if it charged them for lots of parts and hours of labor when tightening a screw was all that was done. One way repair shops can reduce the payoff to dishonest repair charges is through joint ownership with the dealership selling the cars being repaired. In this way the owner of the dealership makes future car sales a hostage to honest repair work. Dealerships depend on repeat sales from satisfied customers, and an important factor in how satisfied people are with their cars is the cost of upkeep and re¬pairs. The gains a dealership could realize from overcharging for repair work would be quickly offset by reductions in both repair business and car sales.  

Automobiles are not the only products in which it is common to find repairs and sales tied together in ways that provide incentives for honest dealing.  Many products come with guarantees entitling the buyer to repairs and replacement of defective parts for a specified period of time.  These guarantees also serve as hostages against poor quality and high repair costs. Of course, guarantees not only provide assurance of quality, they provide protection against the failure of that assurance.  Sellers often offer extra assur¬ance, and the opportunity to reduce their risk, by selling a warranty with their product that extends the time, and often the coverage, of the standard guarantee. 

Knowing that a product is under guarantee or warranty can tempt buyers to use the product improperly and carelessly, and then blame the seller for the consequences. With this moral hazard in mind, sellers put restrictions on guarantees and warranties that leave buyers responsible for problems they are in the best position to prevent.  For exam¬ple, refrigerator manufacturers ensure against defects in the motor but not against damage to the shelves or finish. Similarly, automobile manufacturers ensure against problems in the engine and drive train (if the car has been properly serviced) but not against damage to the body and the seat covers. While such restrictions obviously serve the interests of sellers, they also serve the interests of buyers.  When a buyer takes advantage of a guarantee by misrepresenting the cause of a difficulty with a product, all consumers pay because of higher costs to the seller.  Buyers are in a prisoners’ dilemma in which they are better off collectively using the product with care and not exploiting a guarantee for problems they could have avoided.  But without restrictions on the guarantee each indi¬vidual is tempted to shift the cost of their careless behavior to others. 

Adverse selection is a problem associated with distortions arising from the fact that buyers and sellers often have different information that is relevant to a transaction. Most of this chapter has been concerned with the ways sellers commit themselves to honestly revealing the quality of products when they have more information about that quality than do buyers. But in the case of warranties it is the buyer who has crucial information that is difficult for the seller to obtain. Some buyers are harder on the prod¬uct than average and others are easier on the product than average.  The use of automo¬biles is the most obvious example. Some people drive in ways that greatly increase the probability that their cars will need expensive repair work, while others drive in ways that reduce that probability.  If a car manufacturer offers a warranty at a price equal to the average cost of repairs, only those who know that their driving causes greater than average repair costs will purchase the warranty, which is therefore being sold at a loss.  If the car manufacturer attempts to increase the price of the warranty to cover the higher than expected repair costs, then more people will drop out of the market leaving only the worst drivers buying the warranty.8 

Even though people would like to be able to reduce their risks by purchasing war-ranties at prices that accurately reflect their expected repair bills, the market for these