1. Customer Relationship Management: A Database Approach MARK 7397 Spring 2007 James D. Hess C.T. Bauer Professor of Marketing Science 375H Melcher Hall jhess@uh.edu 713 743-4175 Class 12 Lemons and Signals

3. Lemons and Peaches  =part-worth of quality for owners  V - P  0  V - P  0 Supply of Lemons V, Value of Remaining Product Life P/  1 N Number of Computers

4. Suppose Quality is Observable Price depends on value of computer: P V A mutually beneficial exchange is possible if  V < P V <  V for some . Suppose the highest value computer is sold to buyer with highest taste for quality at the highest willingness to pay. Then all V above  will be sold, and total exchange will be (1-  )N.

5. Suppose Quality is Known only by Seller Price is the same for all computers, P. Supply is Demand is Expected quality= ½ P/  Buy if  ½ P/  - P  0 Equilibrium Price and Exchanges: If  < ½, P*=  (1-2  ) and Supply=Demand=(1-2  )N If  > ½, P*=0 and Supply=Demand= 0 V, Value of Remaining Product Life P/  1 N Number of Computers Supply of Lemons

6. Akerlof’s Theorem: Differences in information about the quality of products cause the market to perform poorly or even stop operation entirely. George Akerlof, Nobel Prize Winner 2001 "I submitted it (“The Market for Lemons”) in June, 1967 to the American Economic Review. I got a reply from the editor which said that the article was interesting but the American Economic Review did not publish such trivial stuff." The article next went to the Journal of Political Economy. Again it was rejected. Akerlof kept trying. "I next sent the article to the Review of Economic Studies. I had been urged by one of its co-editors to do that. Instead it went to another editor whose view of 'The Market for 'Lemons" was decidedly less favorable. It was rejected on the grounds again that it was 'trivial.' Finally I sent it to the Quarterly Journal of Economics which accepted it with some degree of enthusiasm." 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."

7. 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 V L =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}.

8. Separating Low and High Quality A P 1 2 Iso-profit of V=2 Iso-profit of V=1       2Vfor2/AP 1V 1/AP H L

9. Separating Equilibrium A P 1 2 Iso-profit of V=2 Iso-profit of V=1       2Vfor2/AP 1V 1/AP Spence’s Theorem: The only intuitive Nash equilibrium in the signaling game is the separating strategies (A L,P L )=(0,1) and (A H,P H )=(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.

10. 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 The use of advertising by the seller as a signal of quality dissipates society’s resources. The use of higher education as a signal of personal talent dissipates society’s resources. Spence’s work created lots of heat. Why?

11. T=teaser rate for transfer of balances CA=checking account balance (signal) Cost of funds=10% 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 Cost of maintaining checking account balances: for segment 2 twice as high as for segment 1. U 1 = V – T – ½ CA versus U 2 = V –T – 1.0 CA Capital One: Signaling Model T CA.10.20 A D C B.00

12. T CA.10.20 A D C B.00 Offer A and B: both segments choose B (pooling) profit = a(-.10+.10+.10)+(1-a)(-.10) = -.10 +.20a Offer A and D: segment 1 chooses D and segment 2 chooses A (separating) profit = a(-.10+.10+.10)+(1-a)(.10-.10) =.10a Separating is preferred to pooling by CapOne so long as a<1. Competition may force D down to C.