Download - THE RATIONALE FOR GOVERNMENT INTERVENTION IN SELLER-CONSUMER RELATIONSHIPS

Policy Studies Review, Vol. 2, No. 3, February, 1983

A. Setting the Stage for Regulation

THE RATIONALE FOR GOVERNMENT INTERVENTION

Sylvia Lane IN SE LLE R-CONSUMER RELATIONSHIPS

INTRODUCTION

This essay addresses the question “Is there a case to be made for consumer protection?” and the ancillary question “Should the government intervene in seller-consumer relationships?”

First, to define consumer protection, the term means the preventing of physical or financial damage to the buyer of goods or services for personal or household use. The argument made in this article is that consumer protection is a public good, and, notwithstanding those who argue that government intervention only raises costs and distorts resource allocation, consumer protection like many other public goods (disease control) i s not provided in socially optimal quantities in the absence of government intervention. Social optimality, the desired state for a society, is several steps removed from Pareto optimality in that it encompasses not only the realm of exchange (economic) relationships but also all other human relationships. It implies an equitable as well as an efficient society with an equitable income distribution and a socially concerned polity (Rawls, 1965). Consumer welfare would be one of the concerns of such a society.

Pareto optimality, as defined in welfare economics, is the state of the world where no one could be made better off without someone else being made worse off. To achieve Pareto optimality the micro-economic model requires an omniscient rational sovereign consumer with perfect information; costless transactions; frictionless, perfectly competitive markets; and no externalities in production or consumption (Henderson and Quandt, 1980, pp. 287-304). If these assumptions held, it would be difficult to provide justification for government intervention to protect consumers. The case for government intervention largely rests on the lack of realism of the model‘s assumptions.

Consumers are less than perfectly knowledgeable or perfectly rational, i.e., they do not always logically try to act in their own best interests or to maximize utility and act in accord with the economist‘s axioms of preference. They are far from sovereign in our economy. Sellers influence what they buy, how they buy it and determine what is available on the market a t any one time. Transaction costs are present and often very high. Markets are not always smoothly efficient in their operation and rarely perfectly competitive. That producers’ incentives to profit may lead to fraud or harmful products; or that firms and practitioners may for many reasons sell products or services whose quality would not be acceptable to a knowledgeable consumer are not considered in the model or its assumptions. Externalities exist and therefore market prices frequently reflect only private and not social costs and benefits. Consequently, even the market

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envisioned in the micro-economic model of a perfectly competitive economy does not automatically provide the quantity of consumer protection deemed requisite for social welfare.

CONSUMER PROTECTION AS A PUBLIC GOOD

The requirements for a good or service being designated as a public good are that: (1) It be considered by those acting on behalf of the public (legislators, regulators, e t al.) as requisite to the public welfare; (2) It is jointly supplied to the community through legislation or the legal system and one individual availing herselfhimself of this commodity in no way diminishes the supply available to al l or prevents anyone else from enjoy- ing the public good (e.g., police protection); (3) It not be appropriable by the individual (it i s not a right for one person only, e.g., public education); (4) It cannot be feasibly packaged in individual units and bought and sold by individual firms (knowledge about ongoing epidemics); and (5) It is not in the private interest of producers to provide it in a sufficient number of cases to make it available to al l (malaria control) (Due and Friedlander, 1973). True, there is no “pure” public good but consumer protection meets all of these requirements. As a result, as for al l public goods, it must be provided by government if an optimum quantity is to be available.

CONSUMER INFORMATION AND CONSUMER PROTECTION

Providing consumer information is an integral part of consumer protection. According to the micro-economic model of the economy, a rational optimizing consumer voting with herhis dollars i s sovereign, since only those commodities bought in sufficient quantities a t high enough prices to make their production profitable will be produced. The consumer in this model is assumed to have complete and perfect information concerning available commodities-their prices, characteristics, and availability. But with erroneous or insufficient information consumers cannot make optimal choices reflecting their preferences and cast their dollar votes so as to guide the allocation of resources in such a manner as to maximize utility, i.e., subjective value. Markets frequently fail to provide consumers with what they would buy i f they were fully or well informed (sausages without sodium nitrite) (Chase & Schlink, Swagler, Chapters 2 and 3).

There is much evidence that consumers, lacking information, do not make purchases that maximize utility. Consumer complaints are a case in point. But, it is impossible for every consumer in the American economy to have exhaustive information on the thousands of commodities purchased during a lifetime. There are 655,000 individual appliance products alone on the retail-market (Aaker & Day, 1978, p. 407). Not surprisingly, easily understandable relevant information is a commodity that many consumers demand and buy from private sector firms or nonprofit organizations (vit, Consumer Reports) because of individual economic benefit and es- pecially to protect themselves against buying unsatisfactory commodities.

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Rationale for Government Intervention

Consumers, since it is an economic use of time, accumulate information on more expensive or frequently bought purchases or classes of products (Katona & Mueller, 1955; Newmen & Staelin, 1972; LeGrand & Udell, 1964). The information acquired i s capital which saves search costs and/or costs of disappointment, harm, and damage from fraud or potentially harmful or low quality products. The accumulation of relevant information is a major and essential form of consumer self-protection. Govern- ment provision of useful consumer information (such as nutrition labeling) seems to improve buying decisions, and although consumers pay for this as for other public goods (with taxes, with charges or fees) it increases consumer welfare.

Asymmetry of Information Endowments Unfortunately, information endowments are asymmetric. Sellers

have more information than consumers in virtually all segments of the economy. One consequence is that sellers can use information to influence consumer wants dispelling the myth of consumer sovereignty (Galbraith, 1958, pp. 127-1 28). Sellers often limit information provided consumers (the expected life of the product i s rarely disclosed) or provide only that information that will persuade consumers to buy products. They often provide l i t t le or no information, as in the case of potentially harmful products (cigarettes), or they can provide misleading or erroneous information as in cases where consumers are defrauded (aluminum siding scams, worthless patent medicines, etc.). State Attorney Generals' and local District Attorneys' files are replete with cases of consumer fraud. Con- sumers cannot protect themselves without sufficient information to know if a product (for example, a medical treatment) i s a "good" or a "bad" item (Boulding, 1981, p. 271 1. When consumers buy products they would not have bought had they had more or better (truthful and understandable) information, economic resources may be misdirected. Thus, providing consumer protection in the form of information which consumers find useful increases consumer utility and enables the economy to produce more rather than less wanted "goods" as opposed to "bads."

The Producer's Economic Interest Producers (sellers) in our economy can only survive if they profit,

and so, theoretically, they attempt to maximize profit. Therefore, it is in the producers' economic interests to minimize costs and the means of doing so may be by engaging in deleterious practices or producing products that do not meet acceptable standards of quality of knowledgeable consumers. Examples include adulterating products (watering the wine), giving short weight, misidentifying products, using low cost ingredients and materials even though they are of lower quality or questionable worth, providing less information than the public welfare requires, polluting the environment rather than installing means to protect it, not assuring adequate product performance or product safety and writing self-serving contracts. Government penalties for providing misleading information or perpetuating consumer fraud, although they may be high, are often imposed tardily or

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not imposed at all. (It took the Federal Trade Commission twelve years to stop Geritol from advertising "for tired blood.") Some states are more lax than others in enforcing laws against mnsumer fraud (the sale of over- priced home repairs), and provisions of laws vary from state to state. There- fore, it pays many sellers whose prices for the quantities sold cover costs of 'litigation and penalities to continue deleterious practices. But it should be stressed, all producers do not engage in these practices. One of the binding constraints upon producer malfeasance is the fact that if the firm i s to remain dependent upon purchases of repeat buyers or build an attra- tive reputation (goodwill) it must meet the quality standards of i t s buyers. Professional, personal and industry standards may also be binding constraints. Firms with poor reputations for quality do not receive referrals from other firms who fear their own reputations would suffer because of the referrals. Personal standards of many firms' personnel keep them turning out "an honest product" or "doing a good job." Many professional associa- tions have peer review committees to maintain standards, and firms, people and professions are often jealous of their reputations.

Consumers' own standards, however, depend on their less than perfect information holdings, continually more deficient as technology advances, and may not be sufficient for an acceptable degree of protection (flamma- bility of fabrics; micro-wave radiation). Parenthetically, when the product market is oligopolistic, there may not, without government intervention, be a product that meets consumers' standards (of safety, for example) or standards consumers think government should impose; but with a limited number of choices consumers either buy the less than acceptable offering or go without (automobiles).

Government Attempts to Right the Balance Government has attempted to right the imbalance of information.

Measures have generally been in the form of requirements for disdosure such as the Truth-in-Lending laws. Other examples are labeling requirements such as those of the Food and Drug Administration for ingredients or nutrition information; the Department of Commerce requirements for care labeling of garments; or the regulations of the Federal Trade Commission, many of which are attempts to provide "Truth-in-Advertising." Attempts to provide for individual redress in cases of product failure and/or fraud have taken the form of "three day" laws permitting consumers to cancel purchase contracts for commodities bought from door-todoor salesmen within a specified number of days, warranty reform legislation, provision for small claims courts, provisions for class action suits on the state and federal level that may be filed by groups of consumers who have been damaged and a body of consumer law providing private remedies. These hold sellers, strictly liable in the case of defective products and permit consumers who have been harmed to sue (Feldman, 1980; Lane, 1973; Haemmel, George & Bliss, 1975).

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TRANSACTION COSTS

One of the serious omissions in the microeconomic model is the disregard of transaction costs. Transaction costs are all costs associated with a transaction, excluding the prices of the commodities involved. They include money costs, the cost of time and energy, and opportunity costs, i.e., the benefits that could have been gained from the best alternative use of money, time, or energy. Consumers, in reality, maximize transaction costs (costs involved in bargaining, making the purchase, legal costs in respect to contracting and, if necessary, seeking redress, etc.). As indivi- duals they frequently find "it does not pay" to return merchandise, sue or complain to regulatory agencies or to comparison shop for commodities like credit terms, insurance, financial services, etc. Therefore, transaction costs make for less than the socially optimum quantity of consumer self- protection. Where the problem affects many consumers (for example mislabeling) but transaction costs or losses in each case are so small as to make it uneconomic for an individual consumer to take action; or where the individual consumer is relatively powerless to change the situation (persuade the grocery industry) and where even joining with a group with the same objective (which involves transaction costs) may not help, government intervention is required if the situation is to be remedied.

THE LACK OF COMPETITION

The model of monopolistic or imperfect competition stipulates firms competing for consumer favor will not only compete price-wise but also in terms of product attributes (Chamberlain, 1933). In retail markets which are generally characterized by nonprice competition, there are many firms with similar but not homogeneous products, and the consumer has a choice among products with different quality attributes. Quality attributes may include information concerning optimum use, safety features (children's car seats), absence or presence of varying quantities of unhealthful or healthful ingredients (foods and cosmetics), or materials and type of con- struction that make for a more or less durable or satisfactory product (automobiles, other consumer durable goods). In markets characterized by monopoly or oligopoly (relatively few sellers), consumers have less protection from prices above competitive levels, and there may be less regard for the consumer interest insofar as quality attributes are concerned. Consumers have relatively l i t t le leverage in these markets. Feldman (1980) cites the case of the American automobile industry before the advent of significant foreign competition "which offered a product almost ignoring consumer interest in safety, economy and durability" (pp. 25 and 26). Government does intervene to curtail monopoly under anti-trust legislation such as the Sherman Anti-Trust Act, the Clayton Act and the Cellar- Kefauver Act, but the history of anti-trust action shows it to be partially remedial and far from totally concomitant with or best calculated to serve consumer interests (Swagler, 1979, p. 197).

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Sellers, unless they are driven by competition have no financial incentive to provide the consumer with any cost-increasing product feature that will not add to profits, a t least in the long run. Features which enhance quality, add to safety, or increase durability, and these are not mutally exclusive categories, tend to add to costs. Just simply changing a method of production or distribution or adding a step in the retailing process adds to costs. Unless the seller thinks enough consumers will pay for the cost- increasing feature, it will not come into being without government intervention; Even if the feature will pay for itself after it comes into being (open dating), sellers (retailers) may not act rationally (in their own best interest) and resist the initiation of a practice because of inertia, reluctance to change or the initial costs of changing their methods of operation (Feld- man, 1980, p. 25).

THE EFFECT OF EXTERNALITIES

Product prices in nonmonopolized markets only reflect w s t s borne by the firm plus "normal" profits. Firms in all markets can only remain in business in the long run i f they cover their full economic costs. If firms, however, do not bear the cost of polluting rivers or the air or illness caused by their products-negative externalities-then those costs may not be reflected in their product prices. At a price lower than it would otherwise be, greater quantities will be sold than a t the higher price. The firm will produce more "negative externalities" ("bads" rather than "goods") than are socially optimal. Consumer protection, i.e., government action, against the "bads" will be needed if they are not to be permitted or are to be cur- tailed.

Where externalities exist, private costs and social costs diverge. If government intervention takes the form of a tax, the polluter, if the market permits, will raise his price to cover as much of the tax as shehe can, and therefore the quantity of the product produced and sold will decrease. Prices will be higher but social costs will be lowered. In some cases government may simply prohibit the activity or the sale of the product to protect consumers (fireworks, some hazardous chemicals). In other cases the government may subsidize or reward the producer who produces less of the "bad" (tax credit for cleaning up pollution).

Firms generally oppose regulation or taxes whose purposes are to reduce negative externalities unless they receive offsetting rewards. Regula- tions and taxes do add to costs and prices. But it may be to the community's benefit (effective consumer protection) to have the higher costs and prices, less of the good produced, consequent lower pollution, and longer lived consumers.

CONSUMER PROTECTION AS MARKET PROTECTION

Still another reason for providing consumer protection is that some, in the form of quality assurance, is required if markets, where the quality of

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products i s questionable, are not to collapse. This was explained by Akerlof (1970). In markets such as the used car market or the market for lower priced wine where buyers use some statistic, say an average, as an indicator of the quality of prospective purchases, there is incentive for sellers to market poor quality merchandise. The returns for good quality accrue to the entire group of sellers in this market (the average is raised and buyers only pay for the average quality) rather than to the individual seller. Since shehe will only receive the average price shehe may as well sell a product of inferior quality which costs less. As Akerlof states, “As a result there tends to be a reduction in the average quality of goods and also in the size of the market. It should also be perceived that in these markets social and private returns differ, ’and therefore, in some cases, governmental intervention may increase the welfare of al l parties” (p. 488). Private institutions, he indicates, which would have some power (certifying agencies) may come into being since they could affect potential increases in welfare for both buyers and sellers.

Many markets would probably collapse without consumer confidence regarding quality standards assuring safety (milk, meat, drugs). Thus government intervention to assure minimum quality standards in markets for potentially harmful products not only safeguards the public health and safety but may increase producer, as well as consumer, benefits.

CONSUMER PROTECTION AND INSURANCE

The final argument for government intervention in seller-consumer relationships in the form of consumer protection rests on the fact that it would not pay individual consumers, in most cases, to insure against the hazards (damage or harm from faulty products, consumer fraud) from which they are protected under consumer law and government regulation considering the prices that would have to be charged for this insurance, the probabilities of the damaging event occurring and the costs of the damage that would be involved. Nor are many of the events sufficiently predictable to warrant insurance being readily available. How often will the average consumer be defrauded or deceived and what will the damage be in the average case? We s t i l l have too few stat ist ics on this type of risk and no actuarial tables for the appraisal of the value of many risks.

How often will the average consumer suffer harm or damage from a faulty or unreasonably dangerous product and what will the average amount of harm or damage be? Consumers expect that producers will obey the laws and abide by regulations designed to protect consumers; that products will be merchantable and that they, the consumers, will be able to sue when they are not. It is more economic and markets are afforded support when sellers rather than consumers are liable and carry insurance such as medical malpractice or product liability, in case they are sued. Whether sellers pool risks through insurance or not, commodity prices are increased to the extent the responsiveness (elasticity) of demand allows, since sellers s t i l l attempt to maximize profits (Oi, 1973).

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Problems, however, may arise when consumers think they are pro tected and hence buy riskier products. Sellers may not only raise prices to cover their potential liability but also remove riskier products, entailing higher insurance costs from the market, curtailing consumer choice. Con- sumers also are often prone to underestimate risk, and buying riskier products, they assume more risk than is socially optimal. Consumer protection in the form of government intervention to remove highly risky products from the market may thus lower insurance premiums as well as serye the interest of public health and safety.

THE LIMITS OF CONSUMER SELF-PROTECTION

The Reagan Administration spokesmen and other proponents of laissez-faire argue that government intervention in seller-consumer relationships in order to protect the consumer is unnecessary, produces in- efficiency and raises firms' costs and therefore product prices (Friedman, 1962). Problems, they contend, are self-correcting if government will permit sellers and consumers to resolve disputes. But some of the proponents may view a world in which, as indicated earlier, the consumer has full and complete information about the purchase and acts "rationally," the market i s perftxt/y competitive, there are no transaction costs and no externalities. Moreover, and most important, they do not view consumer protection as a public good, may not be concerned with moving toward the social optimum, and think the price system is al l encompassing.

Green (1978) writes, "Consider Friedman's responses to . . . 'Are there externalities?' 'To the extent that the pollution [Nader's term is compulsory consumption] caused by the U.S. Steel Plant there is confined to that city and people generally are truly concerned about the problem, it's to the company's advantage to do something about it. Why? Because if it doesn't, workers will prefer to live where there i s less pollution, and U.S. Steel will have to pay them more to live in Gary.' 'Are there faulty or dangerous products?' It is unlikely.'A producer will be careful about what he puts on the market because he doesn't want to lose business,' but if there are, 'you sue' . . . ." But Green continues, "Gary, Indiana, i s not yet pollution free. Labor (and nonlabor) mobility is, of course, not frictionless (there are costs and some are not part of the exchange system. Workers do trade off salary against environment and having a job, and salary may be more important to them than protecting their health).

"And, i f producers are so anxious about losing goodwill and consumers, why is consumer deception endemic and not episodic?. . . it is assumed that if there is fraud or hazard, consumers will discover this and shun the charlatan. But what about the cost in health and death until consumers sufficiently educate themselves? They may more than offset increases in product prices. [As to1 legal recourse as a solution to market bilk ('you sue') it is a possible but remote alternative for most consumers. There are serious (legal and costly) entry barriers [togoing] to court" (Green, 1978, pp. 486-487).

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SUMMARY AND CONCLUSION

The Reagan Administration overlooks the reality that consumer protection is a public good that should be available to al l a t an acceptable level (the level i s a political decision) if the economy is to function so as to promote social welfare. Individual consumers generally cannot afford the time, the money or the energy nor do they have the information or the power to protect themselves in every case where they do not receive full value or suffer financial damage, or even when they suffer physical damage or mental anguish because of marketplace transactions. Government intervention in the form of consumer protection i s appropriate to reduce consumers' risks of physical and economic loss, harm, or damage to socially acceptable levels (licensure to prevent medical ineptitude etc.); to reduce social cost not minimized by actions of private firms or individual consumers; to keep product liability and malpractice insurance premiums a t levels permitting firms or practitioners to operate at acceptable levels of quality performance and remain in the market; and to assure that consumers have enough confidence in markets so that markets will continue to function and expand.

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Akerlof, G.A. The market for lemons. Ouarterly Journal of Economics, 1970, 843). 488-500.

Boulding, K.E. Ecodymmicz. Beverly Hills, Calif.: Sage Publishing Co., 1981.

Chamberlain, E.H. The Theory of Monopolistic Competition. Cambridge, Mass.: Harvard University Press, 1933.

Chase, S. & Schlink, F.J. Your Money's Worth. New York: Macmillan, 1927.

Day, G.S. Are consumers satisfied? In D.A. Aakw 81 G.S. Day (Eds.), Consumerism: Saerch for the Consumer lncsnat (3rd ed.). New York: Macmillan Publishing Co., 1978.

Due, J.F. & Friedlander, A.F. Government Finance. Economics of the Public Sector (5th ed.). Homewood, 111.: Richard D. Irwin, Inc., 1973.

Feldmen, L.P. Consumer Protection: Problems and Prospect& St. Paul: West Pub- lishing Co.. 1980.

Friedman, M. Capitalism end Freedom. Chicago: University of Chicago Press, 1962.

Galbraith, J.K. The Affluent Society. Boston: Houghton Miff tin Co., 1958.

Green, H.A.J. Consumer Theory. Baltimore: Penguin Books, Ltd., 1971.

Green, M.J. Appropriateness and responsiveness: Can the government protect the consumer? In D.A. Aaker & G.S. Day, (Eds.), Consumerism (3rd ed.). New York: Free Press, 1978.

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Haemmel, W.G., George, B.C., & Bliss, J.J. Consumer Law. St. Paul: West Publishing co., 1975.

Henderson, J.M. & Quandt, R.E. Micro-Economic Theory (3rd ed.). New York: Mc- Grew Hill Book Co., 1980.

Katona, G. & Mueller, E. A study of purchase decisions. In L.H. Clark (Ed.), Con- sumer Behavior: The Dynamics of Consumer Reaction. New York: New York University Press, 1955.

Lane, S. Economics of consumer class actions. The Journal of Consumer Affairs. Summer 1973, pp. 13-22.

LeGrand, B. & Udell, J.G. Consumer behavior in the market place. Journal of Re- tailing, Fall 1964, pp. 32-40.

Nader, R. The Consumer and Corporate Accountability. New York: Harcourt Brace Jovanovich, Inc., 1973.

Newman, J.W. & Staelin, R. Prepurchase information seeking for new cars and major household appliances. Journal of Marketing ReoeBrch 9, August 1972, pp. 2 4 4 257.

Oi, W. The economics of product safety. Bell Journal of Economic 8nd Management Science, Spring 1973, pp. 3-28.

Rawls, J. Distributive justice. In philosophy, Politics end Society. Third Series, Black- well, 1965.

Swagler, R.M. Consumers and the Market (2nd ed.). Lexington, Mass.: D.C. Heath and Co., 1979.

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