Advertising is all around us, but a moment’s reflection should make you wonder how it could exist at all. Think about it: Everyone knows that talk is cheap, so why would we believe a company that’s trying to sell us something? But if we won’t be swayed into buying by, say, a giant billboard or a TV commercial, then why would so many sensible and successful companies bother to advertise?
Economists have been pondering this conundrum for decades. The traditional answer, first offered by economists in the 1980s, starts with the insight that advertising isn’t exactly cheap: Whether it’s a full-page ad in a magazine, a 10-second spot on local radio, or a splashy network ad during the Super Bowl, it costs something to the advertiser. And in many cases, the cost alone gives the ad credibility — so much so that the ad’s actual content is incidental. The real signal of a product’s quality is in the money spent on the ad.
The implicit message is always: “If I’m going to spend millions of dollars on an ad, it must mean I’m good,” says Pedro Gardete, a professor of marketing at Stanford Graduate School of Business. Why? Because otherwise, customers who see the ad will go check out the product, find that it fails to live up to its hype, and decide not to buy it — making the advertising investment a colossal waste of money.
Consumers, the theory goes, understand all this, which is why even an ad devoid of claims can work. In fact, because this explanation for advertising is all about showing a company’s willingness to put its money where its mouth is, the advertiser would do just as well to burn large piles of cash, if only as many people could witness that pricey spectacle.
But “money burning,” as economists call this costly signaling model of advertising, isn’t the only way to explain the existence of advertising or customers’ willingness to believe it. Sometimes advertising packs a punch because of its content, not because of its cost. Advertising always costs something, and sometimes quite a bit, but since an ad claiming high quality costs the same as an ad claiming low quality, both ads count as “cheap talk” in economics lingo: a message whose content has nothing to do with its cost.
Contrary to our intuition, there are times when even cheap talk can be believed. In a 1993 paper, economists Kyle Bagwell and Garey Ramey observed that firms often have an incentive to tell the truth. “They realized that the interests of the company and the interests of consumers are not always opposed,” Gardete explained. Sometimes the market just coordinates — the preferences of consumers and companies match.
House hunting brings this dynamic into sharp focus. Suppose the seller says the house has four bedrooms, but there are really only two. Potential buyers of a four-bedroom home will walk away disappointed from the open house. Even worse, from the seller’s perspective, is that the seller will never reach customers in the market for a modest two-bedroom. “So I hurt myself two ways: I sent away customers who prefer my house, and I attracted those who on inspection don’t like the house,” says Gardete. In this idealized scenario, the market self-organizes beautifully. Because the buyers and sellers want each other, there’s no incentive to lie.
But what happens when the interests of the advertiser and the consumer aren’t such a perfect match? If consumer and advertiser interests match only somewhat, can advertising still be believable and provide benefits for both the firm and the consumers? Gardete wanted to find out, so he built an economic model that treats product quality not simply as either high or low (as Bagwell and Ramey had done in their original analysis) but as a continuous variable: a more realistic world with many types of companies. Gardete’s intuition had told him that in this messier world, companies would have some incentive for dishonesty—but that advertising would still work. Until he ran the model through its paces, though, he didn’t know which way companies would play their cards. Would most exaggerate their quality, would they understate their price, or what?
What he found is both reassuring and disquieting because although there remains a high level of honesty, some companies have an incentive to lie, and it can be hard for consumers to tell the honest sellers from the liars.
“I found that some companies with very low quality will say they’re better than they are, and they couldn’t stay in business if they didn’t overstate their quality,” Gardete says. For example, a company with products that would rate a 1 or 2 on a scale from 1 to 10 has every reason to claim in ads that their products are a 3 or 4, since that would attract customers who want decent quality without scaring away price-sensitive shoppers. "If people knew these sellers’ true quality," he says, "they wouldn’t even go into the store." Once customers do get lured into the store, many discover the poor quality and walk away—but enough settle for the shoddy product that it makes sense for the seller to stick with the formula.
Companies on the high end, in contrast, will simply tell the truth. “They have no incentive to say they’re cheaper than they are,” Gardete says, since doing so will turn away customers looking for the highest quality. Even companies offering middling quality and price tend to present themselves accurately, Gardete’s model predicts. The problem is that customers can’t tell whether they’re dealing with a 4 or 1. “The middle-quality companies will say ‘value for money,’ and the low-quality ones will also say ‘value for money,’” Gardete explains. So, even when the majority of sellers are honest, the few bad apples spoil things for many of the rest. Consumers are always worse off when advertisers misrepresent themselves.
For this reason, Gardete says some degree of truth-in-advertising regulation is necessary to protect consumers, especially when the losses from the lie are large. It’s absolutely right for the Federal Trade Commission, for example, to crack down on fraud in matters of life and limb. But sometimes what’s good for the consumer isn’t necessarily good for firms (who, of course, also provide social value as employers), so regulators must balance the needs of both groups. In fact, Gardete says, we as a society “might like to allow a little misrepresentation because the gains of these firms could be much bigger than the losses for consumers.”
Besides, the way Gardete’s model plays out, consumers weren’t really fooled: When customers see the value-for-money ad, they understand the risk that they might go to the store and not like the advertised product. But the presence of honest sellers makes this a risk worth taking. Consumers realize there’s a chance that those pictures of the house, for example, aren’t realistic. But there’s a chance that they are, so potential buyers visit it and make sure, says Gardete. In other words, “No consumer is really surprised, they’re just disappointed. It’s not like ‘Oh, my god! How is it possible?’”
Perhaps the main lesson for consumers is to take advantage of low-cost ways of gathering product information. “Unfortunately, there is an incentive for firms to misrepresent themselves, so it’s important for consumers to really use information technology, ratings and so on to make an informed decision.”
Advertisers, for their part, can think about ads as more than a way to drum up sales: They’re also a way to learn about consumers, just as consumers are learning about the company. “When you’re positioning your own product or company, it’s hard to know exactly what your customers want,” Gardete explains. But by putting out ads, you’re asking consumers to self-select, based on what they’re looking for, into either responding or not. “By doing this, you get a chance to receive high-quality feedback from people who have at least shown an initial interest.”
Pedro M. Gardete is an assistant professor of marketing at Stanford Graduate School of Business. Kyle Bagwell is a professor of economics at Stanford University. Garey Ramey is a professor of economics at UC San Diego.