By Rohan Jain
As I have learned from reading the book “Naked Economics” by Charles Wheelan, humans tend to be risk-averse when it comes to making decisions. Especially as the complexity levels increase, (such as kids, income, etc.) people tend to lean towards the choice they trust, relate with the most, and think is the most Pareto efficient. Nevertheless, the reasons that these decisions can be so tricky is due to the information asymmetry (unknown information) contained within them. In the moment, we may think our decisions are rational when in fact the marketers are just setting up ploys to make us get their product. So what are some of the factors that go into making a decision like this, and which of those factors do marketers try to take advantage of? There are many factors to this, some which marketers can’t control, like personal utility, costs vs benefits, and working on a budget. But the most efficient and effective way for companies to reach a Pareto efficient outcome (the best possible outcome through trade) is by creating a true “brand” for their product(s). Luckily for marketers, this strategy is much more dominant than others because as human beings, we like to know what to expect. By abiding by our dominant strategies, we can be sure there is no outcome that leaves us unsatisfied.
Let's say you are stuck in a small city in the middle of South Dakota for a day, and there are only two restaurant options for dinner. With a wife and two kids, you are on a relatively tight budget when deciding on a place to eat. Unfortunately, you have never heard of either of the restaurants, but have an idea of what kind of food they sell. One is an Italian place, and the other is a Mexican cuisine. Your wife and you both prefer Italian over Mexican, but just want to check out both of the restaurants’ menus to make sure. You then go on your phone and check Yelp to see how the reviews are. After going to both places, you find that the Italian place is cheaper, but are unsure if either of the restaurants will maximize the utility (personal happiness; enjoyment) of the kids. In this scenario, the family had to spend a lot of time gathering as much information as they could, which can be a steep cost since the kids are hungry. When they made their final decision, they were able to evaluate all of the key variables and make the most rational choice, although they had to be risk-tolerant due to the surprise factor that may come with the choice. Now let's say that instead of the old Mexican place, there is a Chipotle. You instantly recognize the name and know exactly what you are going to expect from it. Because of your previous knowledge about the place, you don’t feel obligated to search for more information because there is no information asymmetry to look for. Even though the Italian place may still be cheaper and Italian food may be your preference, you would still choose Chipotle due to the lack of asymmetric information. Again, when it may seem behaviorally rational in the moment, it is only companies trying to seduce you by providing you with all the information ahead of time. So in the big picture, this decision could have actually ended up being irrational due to the number of variables pointing the other direction. However in reality, you were just following your dominant strategy by valuing expected benefit over costs.
So how are corporations like Chipotle and McDonald's able to create brands so persuasive that it creates dramatic decision jumps for consumers? Let's take McDonalds as an example for this question. In the book, “Naked Economics,” Charles Wheelan explains how big of a role signaling (conveying information about oneself to another party) plays in branding. He says, “The ‘golden arches’ have as much to do with information as they do with hamburgers,” and that “Every McDonald’s hamburger tastes the same, whether it is sold in Moscow, Mexico City, or Cincinnati.” What Wheelan is trying to point out here is that information is the key to signalling, and the more of it one has, the better chance he/she will follow the signal that brands/symbols can be key indicators of signaling However, the abundance of signaling in the form of advertisements in today’s society can be too overwhelming at times for one person to handle. When we encounter commercials on TV, advertisements on billboards, or any other common display of marketing, what we often define as unimportant can actually have a huge impact on our daily lives. Marketers are hired for a reason, mainly because they are ‘masterminds at work’ when it comes to branding. They will get jingles and slogans and $5 Footlongs stuck in your head where you store them in your ‘junk drawer’, but when it is time to make a real decision, you are able to recall some of the signals you may have heard from these campaigns and fill in the information gaps. Advertisements are a perfect way of signaling because they provide the buyer with less information asymmetry, and provide the seller with more business.
So why in some cases is adverse selection (when there is an imbalance between the information a buyer and a seller holds) necessary for something to sell? In cases like restaurants, information asymmetry is the last thing you want because it makes the customer less likely to go there. Although most restaurants would like to have no asymmetric information, it can be hard for local restaurants to appeal to buyers from all over the world because they don’t typically advertise and haven’t franchised their brand in a way to widely provide information. Lucky for them, their market isn’t directed towards worldwide consumers, it is directed towards local consumers who are more familiar with it. This is a whole different market, but in most cases, brands that aren’t franchised tend to be better quality due to less allocation of resources. Mass production tends to be a common indicator of lower quality goods, which is another reason choosing Chipotle/McDonalds over the local Italian place might be an irrational decision. We’ve only talked about one broad market (restaurants), but in markets like retail, adverse selection may be necessary from the seller's point of view. If a seller is trying to sell shoes and has an equal number of peaches (good quality shoes) and lemons (poor quality shoes) in stock, by releasing its asymmetric information, half of its shoes won't sell, causing market failure. Thankfully, when there is a lack of information, we rely on sources such as Yelp, word-of-mouth, rating sites, and many other sources. The hardest part of decision making is knowing who and what to trust based on the information given. When making decisions, the majority of humans are risk-averse and tend to just go with the recognizable brands because even if it might not be the best option, at least you know what you’re getting. Although I believe this thinking is behaviorally rational, I don’t believe it is always practically rational. But for people who are more risk-tolerant, it’s best to take into all of the variables before finalizing a decision such as budgets, maximizing value, costs vs. benefits, personal utility, and others. This way, you are primed to make the most rational decision possible, no matter how high the risk. In conclusion, asymmetric information may be relevant in certain situations, but it is important to realize that the most rational decision is always the one that makes the most sense to your situation.