IMAGINE entering a drug store and asking for a life-saving injection and being told that you could buy one for Rs500 or another with the same prescription for Rs800 — the more expensive one, apparently, manufactured by a better company. Which one would you buy? Even if you buy the one costing Rs800, would you feel comfortable that you are getting the requisite quality? Even if the seller swears that the article is genuine, would you feel confident?

In products where it is hard to tell the difference in quality, all other things being the same, sellers have an incentive to ‘shave’ quality but insist on selling at the highest price the market can bear. Say, there are two producers — the first is selling a low-quality item, the other one that is of better quality. If the buyer cannot distinguish the difference between them easily, the vendor with the lower-quality item has an incentive to sell it at or only slightly below the price of the better-quality product. But, given the incentive structure, the person producing the better-quality item has incentives to shave quality to increase profits.

If both firms, or all firms in an industry, start going down the incentives path, only the poorest-quality item will be produced in this market and selling will take place at the lowest possible price; the market will collapse because of the ‘lemons’. George Akerlof, who is a Nobel laureate in economics, was the first person to point this out very systematically and clearly.

Once such a low-level equilibrium sets in, there need not be any automatic tendency in the market to move away from it. If all manufacturers are producing a certain good that is of the lowest acceptable quality and then selling it at the lowest price, no manufacturer will have any incentive to move away from this if it cannot be credibly signalled to potential buyers that he or she is producing a good that is of better quality and therefore the need to charge a higher price for it.

If an industry starts going down the incentives path, only the poorest-quality item will be produced.

To produce a better-quality injection a higher price needs to be charged. But if there is no way for the customer to know that a company is indeed producing an injection that is of better quality, why would he or she pay more, and hence, why would a manufacturer sell such an injection?

The market can be stable at this low-quality equilibrium. But suppose society does want a better-quality life-saving injection. Is there a way the market could, on its own and without help from state institutions, be able to change the equilibrium? The sellers will have to find a credible way of signalling that they are manufacturing a better product than those selling the same product but of poorer quality.

In some markets this is possible through warranties of various kinds. This is especially the case where durables are concerned. If your television is of a better quality than that of your competitors, you can offer a warranty, say a ‘money-back guarantee’ for three years that the seller of the lower-quality TV cannot. If the latter seller does offer a warranty, since his or her product is of a poorer quality, many more people will come to encash the warranty. Eventually, he or she will not be able to honour the warranty, or will incur losses on a sustained basis. This ability to distinguish your higher-quality product from others in the markets where possible is a way out of the low-quality equilibrium.

The solution through warranties does not directly involve the state. But clearly, we depend on contract and property rights laws for the enforcement of any promises such as warranties, and to that extent a working legal system is needed to ensure that the warranty is honoured by producers.

In many markets, warranties are not an option. Think of the market for edibles or for medicines. The producer will not tell you to use the injection or eat the bread and promise to replace it if you find fault with it. In such cases, other mechanisms are needed. Packaging and branding are options. A company with a ‘reputation’ for quality would be averse to losing it over one pack of injections, or a batch of bread. Companies with branded products can be taken to court if a good legal system exists.

For Pakistan, at least for now, branding is not a solution. Even if you get an injection that has the packaging of a reputable company, you can never be sure if that packaging is original or done by someone in a small illicit workshop. If the economy was a lot more documented, branding would be a solution, but not now, and not across a number of markets.

Stipulation of minimum quality standards by the relevant regulator could be a solution that even a relatively underdeveloped economy could resort to. But so far, historically speaking, though we have established a number of sector-specific and general regulators, we have not been able to set up any effective, independent and efficient regulator. State capacity, issues of corruption and interest group activity, corporate lobbying and the lack of relevant expertise have all conspired against the setting up and subsequent functioning of efficient regulators.

The current state of play is hurting industrial development significantly. Local light engineering cannot compete with the lower-quality products that are being imported or smuggled into Pakistan. This limits the size of their markets and the range of items they produce. Both hurt the development of the industry, their growth and export potential. The same is the case with many consumer products such as edibles, medicines, cigarettes and so on. If markets cannot resolve the issue — and it seems our markets are not at the stage that they can — the state has to step in with regulation. This is the new frontier for us in industrial development.

The writer is a senior research fellow at the Institute of Development and Economic Alternatives and an associate professor of economics at LUMS, Lahore.

Published in Dawn, April 10th, 2015

On a mobile phone? Get the Dawn Mobile App: Apple Store | Google Play