Deceptive Advertising, Regulation and Naive Consumers (Forthcoming, International Journal of Industrial Organization)
Abstract: In markets where buyers have incomplete information about product quality, consumer sophistication strengthens the case for stronger regulation of deceptive advertising by firms. In a model where a fraction of buyers are naive (i.e., cannot update beliefs based on market signals and believe all advertising claims) and they stand to gain from receiving reliable information about product quality, I show that the socially optimal level of penalty is (a) substantially higher than the penalty required to merely avoid deception by firms and (b) increasing in the proportion of sophisticated buyers. The optimal penalty for false advertising not only discourages deception but also reduces prices by eliminating signaling distortion. Moreover, a low level of penalty is worse than no penalty from a social welfare standpoint.
Abstract: Consumers increasingly rely on product reviews by influencers to make purchase decisions. As firms have an incentive to influence the reviewers through unobserved payments, it can be difficult to sustain market outcomes with informative independent reviews. Recent FTC regulations require mandatory disclosure of all paid advertising content so that buyers can differentiate between paid and independent product reviews. This paper investigates the impact of this disclosure policy on market outcomes when the influencer has the expertise to evaluate product quality and influence the beliefs of potential buyers. If the influencer is corrupt with an intermediate level of expertise, a hidden paid review is sustained and disclosure regulation is ineffective (when the consumers are most affected). In markets with high uncertainty about product quality, the disclosure regulation changes the outcome from hidden paid advertising to unbiased independent reviews; this improves not only the consumer and social welfare but also the expected profit of the firm. Further, when the firm has private information about the distribution of its product quality, the disclosure policy facilitates signaling of this private information; a paid (independent) review is posted when quality is more likely to be low (high).