[An updated version of this article can be found at Brand Names in the 2nd edition.]
Consumers always have incomplete information about product availability, quality, and alternative prices. Such "imperfect information" leads them to rely on brand names, which lessen the costs of acquiring product information. By relying on brand names and the company reputations associated with them, consumers can make reasonable purchases without searching or investigating products each time they buy.
Many economists have lamented the fact that consumers put so much reliance on brand names. The problem, as these economists see it, is that this consumer reliance gives companies with established brand names "market power" over the price they can charge. When companies "differentiate" their products with unique brand names and associated advertising and promotional campaigns, they can charge more than others for what these economists claim are "truly" identical products. Brand names lead consumers to make what these economists consider to be artificial distinctions between different products. Companies with respected brand names, therefore, can increase prices without losing significant sales.
The claim that brand names lead to unnecessarily high prices is often based on a comparison between the real world and a world of "perfect" consumer information, where every company in an industry is assumed to sell identical, unbranded ("homogeneous") products. These are the assumptions made in the model of "perfect competition," a simplifying construct sometimes employed by economists. Although imperfect information is completely natural and unavoidable, many economists find the unattainable ideal of perfect competition to be a desirable yardstick for policy. That is because under perfect competition no company has any power at all over the prices it charges. If a company raised its price even one cent above the market price, it would not sell anything. With perfect competition, therefore, no consumer would knowingly pay even one cent more for an identical product that could be obtained elsewhere at a lower price. Not surprisingly, the assumption that homogeneous products are the ideal leads to the incorrect implication that brand names that differentiate products decrease consumer welfare. That, in turn, leads to the policy, advocated by Harvard economist Edward H. Chamberlin in 1956, that trademarks should not be enforced.
More and more of the economics profession, however, has come to recognize the problem with assuming that brand name products are identical. One cannot understand the economic purpose served by brand names without dropping the assumption that we live in a world of perfect information where consumers are omniscient. Consumers, in fact, are not fully informed, and they know they are not. Therefore, they value company reputations—and they are willing to pay more for a product whose producer has a reputation for consistently supplying quality. By doing so, consumers are not acting irrationally. They are simply trying to protect themselves without having to devote huge amounts of time to learning all the details about each company's product. Reputations, and the brand names that go with them, are an efficient source of information for consumers.
Because consumers rely on and pay for reputations, companies have incentives to establish reputations by maintaining and improving the quality of their products. This incentive would be lost if all companies were required by law to sell indistinguishable, homogeneous products. If consumers could not identify the companies that produced the products they bought, individual companies would have no incentive to improve the quality of their products; in fact, each company would have an incentive to decrease the quality of its products. Economist Marshall Goldman has pointed out that this is exactly what occurred in the Soviet Union when brand names were eliminated after the 1917 communist revolution. That is why firms in the Soviet Union were required to identify their output with "production marks." When consumers cannot identify the company that produced what they buy, they have no recourse when they receive a product of low quality. Not only do consumers have no legal recourse, but more important, they have no economic recourse. Without brand names consumers do not know from current purchase experiences which products to buy—and which ones not to buy—in the future.
This repeat-purchase mechanism, where good past performance and a good reputation are rewarded with future profitable sales, and where poor performance is punished with the withdrawal of future profitable sales, provides companies with the incentive to perform in the marketplace. As a result, companies with superior reputations, representing good past performance and the likelihood of future profitable sales, have something to lose if they perform poorly. Their valuable brand names are a form of collateral that is at stake with every sale.
Consider, for example, the cost imposed upon Perrier in 1990 when it was discovered that the benzene used to clean its bottling machinery had contaminated some of its product. Perrier experienced a significant decrease in demand and had to spend large amounts of money on increased advertising, free samples, and other marketing and promotional expenditures in an attempt to recover its market share. Another recent newsworthy example was the image damage, lost sales, and greatly reduced profits suffered by Beech-Nut, the baby food company, when it was discovered in 1982 that its "apple juice" consisted of water, sugar, and flavoring. If brand names were not present in these cases, the large economic punishment imposed on the nonperforming companies would have been lost.
Because companies with valuable brand names that fail to perform have more to lose than companies without valuable brand names, consumers who buy brand name products are necessarily paying for something. They are buying the added assurance that the brand name company will have an increased incentive to take the necessary measures to protect its reputation for quality. For example, an established, profitable company such as Campbell's, with its huge share of canned soup sales, has more to lose if botulism is found in its product than a small marginal company such as Bon Vivant, which went bankrupt after botulism in its canned soup caused a death in 1971. Clearly, Campbell's has a higher stake in avoiding any occurrence of botulism in its product than did Bon Vivant. When consumers buy a brand name product, they are buying increased confidence and reliability.
Can the same be said for purchases of a "standardized" product such as aspirin, where most companies purchase the basic ingredient, acetylsalicylic acid, from the same manufacturer? If consumers are not ignorant or irrational, why would they buy an advertised, brand name product when they could get the exact same non-brand-name product at a lower price? The answer is that all aspirin is not exactly the same. Aspirins are not chemically equivalent. The filler ingredients, dissolve rate, and shelf life may differ from brand to brand. But more important, the higher-priced brand and the lower-priced "nonbrand" aspirins are not economically equivalent. In fact, to producers and consumers the products are necessarily different.
As the Perrier example vividly illustrates, even for a "simple" product, we live in an imperfect world where there is always a probability that something can go wrong. Because of the existence of a valuable brand name, the company selling the brand name aspirin has more to lose if something does go wrong. The company, therefore, has a greater economic incentive to take precautions. This added quality assurance is one of the things consumers of the brand name product are purchasing when they knowingly pay the higher price.
The question, then, becomes not whether consumers are totally irrational when they pay the higher price for a brand name product, but whether they are paying too much for quality assurance. All consumers pay something for brand name assurance; it is merely the amount that consumers pay that varies across products. Even people who say "all aspirin is alike" spend some money on brand name assurance. They do not buy "nonbrand" aspirin off the back of a pickup truck at a swap meet. Instead, they may buy "lower" brand name aspirin, such as aspirin carrying the brand of a chain drugstore. Further, it is significant that consumers buy a much smaller share of such "lower" brand name aspirin in the children's aspirin segment of the market than in the adult segment. Many people decide, as evidenced by their behavior, that although they are willing to purchase less brand name assurance for themselves, they want the higher-quality assurance for their children.
Finally, it is important to recognize that brand names even operate in marketplaces where the government sets product quality standards. The obvious question is: why not rely entirely on government standards to assure company performance? There are two main answers. First, government standards often cannot easily capture some elements of performance. For example, although the government may grade agricultural commodities, such as vegetables, for color, size, and so on, they cannot define and grade characteristics such as taste that are quite important to consumers. Second, government agencies that rate and assure quality are far from perfect. For example, in 1989 the Food and Drug Administration found that several generic drug companies had faked or altered test results submitted to the FDA to get their drugs approved and that three FDA employees admitted accepting gifts from these generic companies. To assure the quality of the products they buy, consumers are right to rely not just on government standards, but also on brand names.
Benjamin Klein is an economics professor at the University of California in Los Angeles and is president of Economic Analysis Corporation.
Chamberlin, Edward. The Theory of Monopolistic Competition, 7th ed. 1956.
Goldman, Marshall. "Product Differentiation and Advertising: Some Lessons from the Soviet Experience." Journal of Political Economy 68 (1960): 346-57.
Klein, Benjamin, and Keith Leffler. "The Role of Market Forces in Assuring Contractual Performance." Journal of Political Economy 89 (1981): 615-41.