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Ashish's Niti

Niti in Sanskrit means policy/strategy/vision. This blog hosts my political views, along with news and commentary. This blog has moved here.

Friday, September 24, 2004

Consumers have an upper hand in free markets in spite of the imperfect information

Alex discusses how consumers can choose products with imperfect information.

I think he misses the point that in a market sellers (or producers) have a lot invested than consumers. Producers might be able to sell a few bad products because consumers don't have all the information they need. However, once consumers realize and the word spreads around, sales will drop and it will be the producer who will be stuck with capital investment and inventory. This risk taken by the producers is the main reason why consumers can 'trust' the producers to some extent. It is also the reason why advertising might be useful. Spending on advertising also represents a vote of confidence by the producer in the product it is advertising. If consumers don't find the purchased product consistent with the advertisement and their needs, the rest of the product inventory won't sell. The producer might be stuck with huge investment in inventory, brand building and capital investment. It is this risk that gives incentives to the consumers to try out products in spite of the imperfect information. Other things being equal (such as previous experience with the product) consumers can filter products based on the investment in the capital, inventory and advertising. In fact, filtering can happen automatically. For example, if a distributor (or wholesaler, or retailer) thinks that the consumers are likely to buy the product they will stock the product. Thus products reach consumers backed by investment by various players in the market.

This goes beyond simply helping consumers make a proper choice after the products are produced. This mechanism ensures that producers (and distributors etc.) undertake only those products that they think are likely to be purchased by the consumers. After all, what is the use of ensuring good choice among already produced products if the producers don't have any incentive to produce "good" products in the first place.

Does that mean that producers will not make mistakes or that they will not think short term? Sometimes yes, producers might not think about long term consequences of their actions. They might be tempted to increase margins on individual pieces of products by reducing the quality (hence costs) or by selling at higher rates. But such behavior cannot go on for long because of the opportunity it will create for the competitors.

So why do we as a consumers feel cheated by producers (or service providers)? Producers try a number of things to protect their vested interests from competition. One such powerful thing is govt. protection. That's why we see lobbying for increased legislation to 'protect' from the vagaries of the market place. It can take form of the licensing requirements, quality standards, anti-trust laws, higher taxes, subsidies, tariffs and duties and so on. It is also important to realize that if producers feel threatened by the competition then so are their employees. Wage earners are a huge lucrative political constituency. Thus, many of the producers might get a free ride on the laws designed to protect jobs (say from cheap imports). It is this protection that enables producers to protect their investment (in capital and inventory) without satisfying the demands of the customers in the best possible way. If markets were truly free then we should have see producers much more worried about consumers and their demands than they are today.

Thus, really free markets contain an in built mechanism to help consumers make better choices in spite of the imperfect information. It is the competition limiting legislation that impedes this mechanism and causes consumers to feel powerless in a marketplace.

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