In a totally efficient market, product price should correlate with product quality. Premium gas should be more expensive than regular gas. However, in reality, in most product categories, price doesn’t correlate with quality. I’d like to understand which factors contribute to this gap and how we can close this gap as much as possible.
Price Doesn’t Always Correlate With Quality
For 100 years, many researchers have sought to understand the relationship between price and quality (Chase & Schlink, 1927). Researchers use consumer reports as a proxy of product quality. Then they look into more than 200 products to determine the correlation. The evidence reported in the literature indicates that, in the United States, particularly frequently purchased consumer packaged goods display a weak and often negative relationship between price and “objective” quality. Some other studies (Faulds & Lonial, 2001) look into similar data in Europe; the lack of a strong price-quality relationship appears to be an international phenomenon.
This was shocking, at least to me. Why doesn’t the price correlate with quality at all? Do consumers make the purchase choice randomly? Is it normal or are some factors preventing the market from behaving more efficiently?
Some Product Categories Have Stronger Correlation Than Others
Product categories have strong correlation than others should help us to understand what is the key factor drives correlation
In general, more expensive, durable products have stronger correlation than other, non-durable products. This makes sense, as consumers will spend more time looking into details and comparing them against other alternatives. However, this doesn’t solve the issue for CPG companies that sell only low-price, non-durable products.
Perceived Price-Quality Rating Has a Much Stronger Correlation
Another way to increase the correlation is to take a look at the correlation between Perceived (Subjective) quality and price. As we can see in the chart below, both durable and non-durable products have a very strong correlation for Perceived Price-Quality.
This means that consumers want to pay more for a high-quality product. They just don’t quite know the objective product quality. When consumers are given enough information, they should be able to make logical choices, which will improve the price-quality correlation
Additional Information on Product Quality Can Close the Gap Between Perceived Quality and Objective Quality
I found three case studies that show how additional information on product quality can improve the correlation between price and quality.
Apartment (Harano & Seshita, 2014)
An apartment certainly belongs to the expensive, durable product category. Most of the product attributes (e.g., Size, Equipment, Location) have a strong correlation with price. However, if the apartment is developed by a small developer, these correlations don’t quite work. Typically, small developers cannot enjoy the same price range as other developers.
When small developers decided to ask a third party to evaluate the quality of an apartment and attach a report to the product, they found that the correlation improved from -0.07 to 0.01. If developers are willing to guarantee the quality for 10 years, this will improve the correlation from -0.07 to 0.11. It’s the same product, but this additional information helps consumers make better decisions.
In the wine industry, quality ratings are provided by (among others) the Wine Spectator, the Wine Advocate, and the Wine Enthusiast. Because quality matters to consumers and because the opinions of these experts are deemed credible, a wine’s price should be a positive function of how well it is rated by the critics. Many researchers have found a strong and unwavering relationship between published quality ratings and product prices.
Interestingly, in the many blind tasting experiments, even the experts cannot really tell the difference among wines. Although wine has the most established rating system, it might be the most difficult product for which to get an objective evaluation.
Limited Information on Quality Destroys the Value of the Entire Market
On the other hand, if we artificially remove the critical quality information, it will destroy the value of the entire market. It will diminish the return of sellers, buyers, and the platform.
eBay is a great marketplace for researchers to study because it has a relatively efficient market and all the information is available on the website. The reputation mechanism is the most important product feature of eBay enabling buyers to distinguish good sellers from bad sellers. The results show that removing the reputation mechanism increases low-quality sellers’ market share, lowers prices, and, consequently, reduces sellers’ profits by 66% and consumer surplus by 35% (Saeedi, 2018).
Absent any reputation mechanism, the model becomes a static model with adverse selection. As a result, higher-quality sellers face lower prices and, therefore, lower market shares. In contrast, the market share of low-quality sellers increases. This decline in average quality in the market leads to a further decrease in prices and, consequently, a shrinkage of the market and its unraveling. In a normal situation, powersellers and stores can enjoy up to 7% of the price premium.
The financial market is generally believed to be much more efficient than other markets involved in any physical object. Financial market participants absorb a large amount of news, or signals, every day. Processing a signal involves quality judgments: News from a reliable source should lead to more portfolio rebalancing than news from an obscure source.
When ambiguity-averse investors process news of uncertain quality, they act as if they take a worst-case assessment of quality. As a result, they react more strongly to bad news than to good news. Moreover, shocks to information quality can have persistent negative effects on prices even if fundamentals do not change.
This phenomenon is a bit similar to the famous lemon problem. If a buyer doesn’t have enough information to make a decision, the buyer tends to believe the worst and treat the item as a bad product. As a result, the bad product will push out the good product, which is devastating to the entire market
I believe that attention is one of the important elements of media quality. This information was not available even 5-10 years ago. Currently, there is almost no correlation between the CPM (i.e., price) and attention (i.e., quality). Based on the research and analysis above, more quality information should make the correlation between quality and price positive. It should be a very healthy development for the whole industry.