Is Less Information Better?

Coarse information, monopoly, and product quality

The government is frequently involved in the rating of goods by quality. This is so standard a use that we have forgotten how strange this actually is. When the government rates the quality of a healthcare plan or the energy efficiency of an appliance, it needn’t be involved in banning or otherwise regulating the quality of the goods. Rating the quality of a good is something that private businesses do all the time, between Consumer Reports, Underwriter’s Laboratory, and similar institutions. So why is the government involved in ascertaining quality?

And why is the information given so coarse? Take the Energy Star rating system. The signal given is a binary one, consisting of whether or not the product simply reaches the minimum standard. We have no ability to differentiate the products which are very efficient from the products which are just efficient enough. The government could provide this, but chooses not to. Why?

It turns out that you can actually improve consumer outcomes by giving the consumer less information, rather than full information. Consumer welfare is higher when they have imperfect information, but not when they have all or no information.

Suppose that there is a single firm offering a product which varies in its quality. Quality is a linear function of investment into quality. Let’s also grant that the price which a firm can charge for a product is in some way constrained – this is more believable for health insurance, but in any case isn’t necessary to our story, it simply makes the example simpler. We assume that the consumer has full information over the quality of the product. Given this setup, the monopolist can maximize profit by underinvesting into quality, just the same as how it might underproduce the quantity of a product. The reason for this is that the company has to provide the same level of quality to everyone, and so it doesn’t bring in enough consumers to make the last, socially optimal, investments into quality happen.

What happens if information is totally imperfect? If we know nothing about the quality of the product, the only stable equilibrium is that the company invests the bare minimum needed for the plan to exist, and everyone knows this. It is this – that the monopolist will do the bare minimum to achieve a standard – that allows us to raise welfare with coarse standards. Suppose the government creates a program like Energy Star, which rates a product as “good” or “bad”. If the threshold is above the monopoly level of quality, and the profits are higher than the no information equilibrium, then the monopolist will increase the quality closer to the social optimum.

I learned this from Benjamin Vatter’s incredible paper “Quality Disclosure and Regulation”, although it has its ultimate origin in Spence (1975). The logic generalizes to any instance in which quality is variable, and it is difficult to ascertain what the quality of a product is. The “punchline” of the Vatter paper is that it spends all this time working through the logic of coarse information, and suggests substantial changes to how Medicare Advantage judges the quality of plans, but over 90% of the possible welfare gains are simply due to reweighting what the government cares about to be closer to what the consumer actually cares about. Such is life!

But why is it the government involved in certifying products? It is difficult to profit from information, so quality is generally certified in the private market by the supplier paying an entity for this. They have no reason to correct the monopoly distortion, so it is, in fact, necessary for the government to step in and provide information on quality in imperfectly competitive markets.