Professional Documents
Culture Documents
Class 12
Class 12
Class 12
Spring 2007
Customer Relationship Management:
A Database Approach
Class 12
Lemons and Signals
James D. Hess
C.T. Bauer Professor of Marketing Science
375H Melcher Hall
jhess@uh.edu
713 743-4175
Noah
Noah Hess
Hess
Hess
Noah Noah
Lemons and Peaches
Number of
Computers
=part-worth
V - P 0 of quality for
N owners
Supply
of Lemons
V, Value of
P/ 1 Remaining
Product Life
Demand for
Number of Computer of
Computers Value V
V - P 0
N N
Demand
P
P/V 1 Taste for V 1 Price
Quality
Suppose Quality is Observable
Akerlof believes that journal editors refused the article both because they feared the introduction into economics of
informational considerations and “...they also almost surely objected to the style of the article which did not reflect the
usual solemnity of economic journals."
Talk is cheap,
but cheaper for high quality brands
A new brand is about to be introduced that can have high or low quality: V H=2
or VL=1. The company learns the quality of its brand from pre-test markets but
the general consumer does not and thinks the probability of a high quality
brand is .
Cost of advertising: A/2 for the high quality firm
A for the low quality firm,
where A is the target advertising rating points.
Profit (A,P|V)=P-A/V, where V{1,2}.
P
Iso-profit of V=1
Iso-profit of V=2
2 1
1/2
A
P A / 1 for V 1
P A / 2 for V 2
Separating Low and High Quality
P
Iso-profit of V=1
Iso-profit of V=2
2 H
1 L
A
P A / 1 for V 1
P A / 2 for V 2
Separating Equilibrium
P
Iso-profit of V=1
Iso-profit of V=2
A
P A / 1 for V 1
P A / 2 for V 2
Spence’s Theorem: The only intuitive Nash equilibrium in the signaling game is the separating
strategies (AL,PL)=(0,1) and (AH,PH)=(1,2).
Michael Spence won the 2001 Nobel Prize in Economic Science (sharing it with George Akerlof and Joseph Stiglitz).
This was unusual because the award cited his doctoral dissertation, Market Signaling. Unlike Akelof, whose “Market for
Lemons” was not well-received immediately, Spence was a superstar out of the gate. He wrote his dissertation in 1972
and by 1975 was a Full Professor at Harvard; normally this takes a dozen years. In fact, after that dozen years, Spence
was the Dean of the Faculty at Harvard.
Spence’s work created lots of heat. Why?
The total welfare of the economy is the sum of expected profits of the company
and the consumer surplus: TW=E+CS=(2-1/2)+(1-0)(1-) + 0=1+/2.
Suppose that advertising was not legally permitted. Then the total welfare would
come from a pooled equilibrium where price is 1+. It is always the case that
1+/2 < 1+, so
Segment 1: size=a, would contribute beyond a 0% teaser year by holding debt for 2 more years
Segment 2: size=1-a, would break even with teaser rate of 10% and payoff all balances
U1 = V – T – ½ CA versus U2 = V –T – 1.0 CA
T
A
.10
C D
.00 CA
.10 .20
B
T
A
.10
C D
.00 CA
.10 .20
B