By Daniel B. Klein
When you buy a good or service, you rarely have perfect knowledge of its quality and safety. You are justifiably concerned about getting “ripped off.” Thus the need for consumer protection.
Economic activity flourishes when consumers can trust producers, but the consumer must have grounds for trust. Consumers value, then, not only quality and safety, but also the assurance of quality and safety. Trust depends on assurance.
free markets generate numerous forms of assurance. While it may be impossible to verify the quality of prospective transactions, you can often verify that of past transactions. Reports circulate in various forms—from informal gossip to carefully tended data banks and evaluations—generating a producer’s reputation. “Reputation” may be defined as the relevant current opinion of the producer’s trustworthiness.
Producers gain by providing assurance, so they seek to build, expand, and project a good reputation. They create and display brand names, logos, and trademarks, umbrellas under which their transactions are grouped in the minds of consumers. They manage the extent and scope of their services to generate the repetition and pattern of dealings that give their name and reputation cogency. Once established, a good reputation can be extended to other lines of service where trust had previously been limited. Gasoline suppliers, for example, built brand names so motorists would trust the product at roadside filling stations, and then extended the trusted name to automotive services. Conversely, a producer’s failings or misdeeds damage his reputation and induce consumers to shun him.
For services such as medical therapies or divorces, in which consumers and producers interact perhaps only very infrequently, the grounds for repeat dealings are thin. The demand for assurance in these cases creates opportunities for middlemen to emerge, to serve as a bridge of trust between the consumer and the producer. Consumers, for example, do not buy pharmaceuticals directly from Pfizer or Merck, but rather from established retailers. The local drug store has extended dealings with both the consumer and the producer. Also, the middleman shares some of the producer’s expertise and, to some extent, serves as the consumer’s knowledgeable agent. A nexus then links the parties. To the consumer, the middleman is a friend, and the manufacturer is thus like a friend of a friend. One of the important functions of all retailers, hospitals, clinics, dealers, brokers, and firms is to generate the reputational nexus that brings assurance to parties who would otherwise meet only infrequently or in isolation.
Producers typically put on their best face and will tend to conceal their failings, and this creates opportunities for a parallel industry of record-keeping, evaluation, and certification. These third-party practitioners range from neighborhood mavens to industry inspectors to product raters to medical schools. In any of these varieties, the agent may be called a “knower.” Knowers have some knowledge that the consumer values but does not have. (Some use the term “certifier,” but that term is too narrow.)
Sometimes, the consumer pays knowers for reporting on producers. Consumers pay Consumers Union for its magazine, Consumer Reports; patients pay doctors to recommend drugs; employers pay agencies to screen prospective employees; employees pay agencies to screen prospective employers; and home hunters pay agents and inspectors to evaluate properties.
Other times, the producers pay knowers. Electronics manufacturers pay Underwriters’ Laboratories to evaluate the safety of their products; corporations and governments pay Moody’s or Standard and Poor’s to evaluate the securities they issue; corporations pay accounting firms to conduct an audit; kosher foods manufacturers pay Orthodox Union to certify their preparations; and students pay universities, institutes, and training programs to certify their abilities.
In all such cases, the producer applies to the knower and hopes to receive a certification or seal of approval that he can broadcast to prospective consumers. Word of his trustworthiness may freely flow to anyone. Consumers (or their savvy agents and middlemen) recognize such seals of approval and gain assurance of trustworthiness. The knowers, after a fashion, rent out their own good reputation to producers and have a strong incentive to do so responsibly; if they do not, other knowers may displace them. In the assurance-producing industry, as in any industry, free competition works well.
In addition to these practices, five other paths to assurance exist:
1. Producers demonstrate quality and safety and make the content of promises clear and publicly understood by such means as advertisements, displays, sales assistance, labeling and packaging, and try-out periods.
2. Traders restructure the relationship to reserve for the consumer an advantage held until the end of the relationship, by such means as warranties, guarantees, return policies, security deposits, and simply withheld payment.
3. Consumers and their agents test and monitor producers and third-party knowers using unannounced inspections, decoys, undercover operatives, investigations, and second opinions.
4. The failings of a producer are exposed by rival producers in competitive advertising, product comparisons, and contests.
5. By making visible investments that would be profitable only for a high-quality product, producers signal quality by advertising, obtaining accreditations, and making long-term investments in design, facilities, and so on.
The Internet is vastly expanding all forms of information exchange and reputation building. Critics regularly fault e-commerce for failings in privacy, security, or trust, but the pattern has been for each trouble to be fleeting. Almost as fast as the troubles emerge, entrepreneurs invent e-solutions, usually taking the form of a middleman (such as PayPal, Amazon, and eBay) service or a knower service (such as TrustE, BBBOnline, and Verisign).
On top of all these creative efforts, there is tort law and contract law, which work on the principle of allow-and-respond. That is, we are free to enter into transactions, but once authorities determine some kind of tort or undue hazard, the activity responsible is curtailed or the damages are redressed. When a surgeon cuts into the wrong organ, he is liable for damages. A quack who persists in defrauding consumers may face a court injunction on his products or services. The late political scientist Aaron Wildavsky argued that the allow-and-respond approach provides for open-ended creative developments, self-correction, and resilience.
Another form of consumer protection is government regulation. For example, the U.S. Food and Drug Administration (FDA) calls itself “the world’s premier consumer protection regulatory agency.” Other examples of consumer protection by regulation are occupational licensing, housing codes, the Federal Trade Commission, the Consumer Product Safety Commission, the Securities and Exchange Commission, and the National Highway Traffic Safety Administration.
These kinds of protections generally involve restrictions on freedom of producers to sell goods or services that the government has not certified. Here the principle is banned-until-permitted. The main problem with such restrictions is that, by reducing the range of choices available to consumers, they make consumers worse off. Even if some of the goods and services would have been “rip-offs,” the vast majority of suppressed goods and services would have fulfilled the consumer’s expectations. The case of suppression best documented by economists is the FDA’s suppression of drug development and information, but economists have shed light on many other cases of suppression, such as those from licensing restrictions.
Thus, the regulations impose costs. The question is: Do they deliver benefits that redeem those costs? To assess the benefits of consumer protection laws, we need to understand how well protection is (or would be) supplied absent the governmental “protections.”
In his 1962 classic, Capitalism and Freedom, Milton Friedman posed a fundamental challenge to occupational licensing. His challenge still stands, and, indeed, applies to all the banned-until-permitted-type regulations: even if you believe that information and assurance are, for whatever reason, inadequately supplied, that might justify, at most, a government effort to supply the missing information. Instead of occupational licensing, Friedman preferred a governmental system by which practitioners could earn state certification in the occupation, but were left free to practice and market their services even if they chose not to be state certified. Consumers would be able to choose from a free, legitimate market of plumbers, electricians, barbers, and doctors, both state certified and noncertified. Likewise, the FDA could offer safety and efficacy certification services; manufacturers could seek FDA certification if they so desired, but would be left free to produce and market the product without FDA certification. This would free consumers and their agents and knowers (doctors and pharmacists) to choose a certified or noncertified drug. Friedman, in other words, said that the supposed deficiencies could justify, at most, only governmental certification services analogous to those of Underwriters’ Laboratories—that is, without compulsion. This approach would allow for competing forms of assurance; it would not lock in or privilege the governmental form. Despite the fact that Friedman’s basic challenge has often been posed over the last forty-five years, to my knowledge no one has ever offered a counterargument, much less a persuasive counterargument.
Capitalism, from the Concise Encyclopedia of Economics.
Risk and Safety, from the Concise Encyclopedia of Economics.
Daniel B. Klein, Drug-Approval Denationalization. April 2009.
Phillip Maymin, Why Financial Regulation is Doomed to Fail. March 2011.
Peltzman on Regulation. EconTalk, November 2006.
Townsend on Development, Poverty, and Financial Institutions. EconTalk, March 2011.
Admati on Financial Regulation. EconTalk, August 2011.
Bureau of Consumer Protection, Federal Trade Commission.
Consumer Protection, FDIC.