Products of Their Environment

Competition has a surprising effect on quality, says Praveen Kopalle.

Between 1995 and 2002, the Federal Trade Commission investigated 627 cases of deceptive advertising practices. All but one were found to be in violation of the law. The popular press, meanwhile, has reported on scores of instances—in industries ranging from toys to pharmaceuticals—where a product’s advertised quality was far worse than its actual performance. Is the world just full of hucksters preying on gullible consumers, or is there some deeper force at work?

That’s the question Praveen Kopalle, a professor of marketing at Tuck, investigates in “The Impact of Competition, Brand Equity, and the Cost of Overstating Advertised Quality, Quality, and Price of New Products,” a working paper he co-authored with Columbia Business School professor Donald Lehmann.

Kopalle has been investigating truth-in-advertising since his days as a Ph.D. student at Columbia. Later, in 2006, he and Lehmann collaborated on a paper that examined the dynamics of truthful advertising in the case of a monopoly. They found that monopolists can’t say whatever they want about their products—eventually, consumers will be irredeemably disappointed and demand a better product. “We showed that if the future is sufficiently important, they wouldn’t overstate quality,” Kopalle says.

In their latest paper, Kopalle and Lehmann add the complicating factor of competition into the mix, studying how two firms introducing a new product—say, tires—would impact each other’s price, quality, and advertised quality. “We thought, Maybe there’s something about competition that changes the dynamic, ” Kopalle says. It turns out, there is. Competition actually encourages a firm to overstate the quality of new products, as a defensive, prisoner’s dilemma-type mechanism against the inflated quality claim of its competition.

Kopalle and Lehmann reached this conclusion by building a game-theoretical model that assumes a given cost function for production. In the absence of collusion, the firms will produce a $60 tire with a life of 50,000 miles, but an advertised life of 60,000 miles—an overstatement of quality. But if the firms could somehow agree to advertise truthfully (a violation of antitrust law), they would actually make more money. This is because being truthful about quality prevents the customer from being disappointed and results in more return business.

The authors also created a model that predicts firms’ decisions when there are legal costs to overstating quality (such as fines from the FTC). Here, they found that as potential legal costs increased, the gap between advertised quality and actual quality shrunk. This makes intuitive sense. Firms that are fearful of expensive fines or litigation from false advertising will be more truthful about their products. Yet there is a twist. The specter of legal costs also encouraged the firms to produce a slightly lower-quality product. “In effect, legal pressure designed to help customers by forcing honest disclosure of quality may produce a reason for competitors to implicitly cooperate by competing less strongly on quality,” they write.

Kopalle and Lehmann tested these models in two ways. In one exercise, they asked MBA students to decide the quality, price and advertised quality of new tires, given certain parameters on costs, competition and likelihood of legal action for false advertising. The responses showed a general tendency to overstate quality, but that tendency decreased with a higher risk of legal costs. The existence of competition improved quality, increased quality claims, and decreased price. Departing from the model, the presence of legal costs and competition did not lead managers to reduce quality. In another test, the authors studied data from FTC cases on deceptive advertising. They found that the highest fines went to the most egregious violations, and that there is a significant positive correlation between the level of competition and the overstatement of quality.

Kopalle draws some interesting conclusions from his findings. “For regulators, it seems to make sense to focus on situations where there is more competition, because that’s where deceptive advertising is most likely,” he says. Businesses are faced with a trickier takeaway: being truthful is only good if your competition is truthful as well, but cooperating with them is against the law. Perhaps managers should simply pledge to follow what they learned in kindergarten: don’t lie.