Encyclopedia of Law & Economics - 5110 INFORMATION REGULATION (INCL. REGULATION OF ADVERTISING)

5110

INFORMATION REGULATION (INCL. REGULATION OF ADVERTISING)

Paul H. Rubin

Department of Economics, Emory University

© Copyright 1997 Paul H. Rubin

Contents

Abstract
1. Introduction
2. Regulation of Price Advertising
3. Regulation and Types of Goods
4. Deception by Omission and Mandated Disclosures
5. Regulation of Health Claims
6. Advertising by Lawyers
7. Remedies
Bibliography on Information Regulation (incl. Regulation of Advertising)(0520)

Abstract

There are three major policy implications from the analysis of advertisingregulation: Advertising of truthful information should not be restricted byregulatory authorities; deception is most likely and most harmful in the case of"credence" goods, and regulation is most useful (if it is useful at all) in the caseof these goods; and laws or rules mandating disclosure (as opposed to lawsbanning explicit deception) are generally not needed, and oftencounterproductive. These points are applied in particular to regulation of priceadvertising, of health claims, and of advertising by attorneys. An importantpoint of the analysis is that advertising can help markets move to new equilibria,and excess regulation can retard such movements, with consequent losses inconsumer welfare. The role of the FTC is stressed throughout since this agencyuses economic analysis in its regulation of advertising.

JEL classification: D83, K29, M37

Keywords: Information, Advertising, Lawyers, Search Goods, Experience Goods,Credence Goods

1. Introduction

More than many areas of law and economics, the literature on regulation ofinformation and deception has been a policy oriented literature. This may bebecause much of the literature has been generated by economists and attorneysassociated with the FTC who initiated their research as part of a policy orientedanalysis. It is also true that most of this literature is from a statutory andregulatory, rather than from a common law, setting; an exception is Jordan andRubin (1979). In any event, in discussing this literature it will be useful toorganize it in terms of policy related considerations.

Coase (1977) has argued that advertising ("commercial speech") deserves asmuch protection as any other form of speech. Singdahlsen (1991) makes a similarargument with respect to private competitor suits, although his reasoning wouldapply more generally. Of course, there are criminal and civil penalties for explicitfraud, so the regulation that occurs is for information violations that do not riseto this level. Fraud, including deception, is discussed in Lott (1996). Moreover,it is useful in many cases for government to devise an appropriate metric, orscoring system, for measuring some attribute. The U.S. Truth in Lending statuterequires the use of the Annual Percentage Rate as the interest rate; the FTC"R-value" rule requires the use of R values for measuring the effectiveness ofinsulation. [See Beales, Craswell and Salop (1981)]. There is a tenable positionthat these should be the only functions of government regulation of information,and one with which I have much sympathy. However, it is not a position thatpolicy makers have adopted. In what follows, I assume that there will be someregulation of advertising beyond this minimal level, and ask what efficientregulation would look like.

A general point is that if one believes that there is some market failure causedby a lack of information, then the preferred solution is to provide the missinginformation, rather than regulate the market directly. Schwartz and Wilde (1979)provide a theoretical basis for this result. Viscusi et al. (1986) provide someevidence of consumers ability to use information effectively in the context ofsafety regulation.

The literature has derived three major policy conclusions. First, advertisingof truthful information should not be restricted by regulatory authorities.Second, deception is most likely and most harmful in the case of "credence"goods, and regulation is most useful (if it is useful at all) in the case of thesegoods. Finally, laws or rules mandating disclosure (as opposed to laws banningexplicit deception) are generally not needed, and often counterproductive.

In the next three sections, I discuss these issues: advertising and prices;regulation and types of goods; and mandated disclosure. The following twosections examine regulation of particular types of advertising that have beenparticularly well studied in the literature: health related advertising andadvertising of legal services. I then discuss remedies for deception. Theeconomic literature on advertising is voluminous, and I mention only those partswhich are relevant to issues of information regulation and deception. For somemore general surveys see Comanor and Wilson (1979); McAuliff, (1987); andEkelund and Saurman (1988). There have been several papers examining theimplications of the economics of information for the regulation of deceptiveadvertising: Schwartz and Wilde (1979); Jordan and Rubin (1979);Beales,Craswell, and Salop (1981); Craswell (1985), Craswell (1991); Muris (1991); Rubin(1991). I rely heavily on these papers, and particularly on Rubin (1991) in whatfollows. A thorough summary of Supreme Court cases on the issue from aneconomic perspective is available in McChesney (1996).

First, I introduce some institutional background for the U.S. While theparticular institutions discussed apply in the U.S., similar functions may beperformed by other institutions in other countries. There are at least five sourcesof regulation of advertising: The Federal Trade Commission (FTC); other federalagencies, such as the Food and Drug Administration (FDA) ; state attorneysgeneral; industry self regulation, under the auspices of the National AdvertisingReview Board (NARB) or the National Advertising Division (NAD) of theCouncil of Better Business Bureaus (American Bar Association (1989); andprivate civil litigation under the Lanham Act and other statutes or common lawdoctrines, including self-regulation by professional societies including local ofstate bar associations. Of all of these regulatory bodies, the FTC is now the onlyorganization with responsibility for advertising regulation which explicitlyconsiders economics in its decision making. Economists and attorneysassociated with the FTC have contributed a significant share of the literature onadvertising regulation. Of those cited here, these include at least: Altrogge,Beales, Bond, Calfee, Calvani, Craswell, Ippolito, Jacobs, Keith (Masson),Langenfeld, Lynch, Kwoka, Mathios, McChesney, Muris, Murphy, Nash,Pappalardo, Pitofsky, Plummer, Porter, Rubin, Salop, Schneider, Shughart, andSteiner. [See also Calvani (1989)]). McChesney (1996) shows that the SupremeCourt at one time used economic reasoning in its commercial speechjurisprudence, but has more recently moved away from this form of analysis.

One issue in regulating advertising is the question of the burden of proof:do regulators need to prove that an ad is deceptive, or must advertisers provethat it is true? In 1970, the FTC shifted the burden of proof. Before that time, theagency was required to prove deception. After 1970, an advertiser was requiredto have adequate "substantiation" for an ad, meaning essentially that theadvertiser had the burden of proof. Sauer and Leffler (1990) have shown that thischange caused advertising to become more informative. On the other hand,Higgins and McChesney (1986) have shown that the main effect was to provideincreased profits to large advertising agencies. Singdahlsen (1991) shows thatthis issue also arises under private litigation under the Lanham Act. This issuecould benefit from further research.

2. Regulation of Price Advertising

"Deceptive pricing" is the advertising of reference prices which are not actuallycommon transaction prices. Ads like "Regularly $100, now $75" or "$100elsewhere, here $75," where $100 is the reference price and $75 is thetransactions price, are sometimes considered deceptive unless there have been"enough" sales at the $100 reference price, where enough can be defined invarious ways. If a product usually sells for $75 and the firm advertises it as beingnormally $100, on sale for $75, this ad will have no immediate benefits. That is,consumers are not given any new options, since $75 is the normal price. This iswhy such ads are sometimes challenged as being deceptive. Nonetheless, theprocess started by this ad will likely lead ultimately to lower prices forconsumers. Price conscious consumers will be drawn to this firm since it isstressing price in its ads, and all consumers will be given some informationabout the distribution of prices in the marketplace. Other firms will be forced torespond to the ad, and some will respond by actually lowering prices below theircurrent level, in part because of the price competition started by the informationconveyed in the ad. Ultimately, even the firm initially advertising a price of $75may be forced to sell for $70 as price advertising spreads throughout theindustry. On the other hand, if the ad is initially stopped as being "deceptive"information about low prices is less likely to spread.

One general point which will recur in the analysis is that in analyzingadvertising it is important to distinguish markets which are in equilibrium fromthose which are not. Schwartz and Wilde (1979) indicate that high price equilibriaare unstable, so that advertising of better prices or terms can destroy a"monopoly" equilibrium in an industry. For a market to be in disequilibriumimplies some informational failure, and advertising, by providing information,can move markets towards equilibrium [Ekelund and Saurman (1988)]. Forexample, a market may be in a disequilibrium with prices above the equilibriumlevel. Advertising may be an effective method of moving from the high priceddisequilibrium to the low priced equilibrium. During the transition some ads mayappear deceptive, but stopping these ads may have the effect of retarding themovement towards the new equilibrium. The general point is that there shouldbe no restrictions on true advertising of prices.

Though the FTC does not generally bring cases involving deceptive pricing,the states often do. There are two types of allegations in such cases. One is thatgoods are not truly available at the advertised transaction price. A second claimis that prices are deceptive because consumers view price as a signal of quality

and a fictitious reference price will mislead consumers into overestimating thequality of the good. I consider each type. Both are inconsistent with theSchwartz and Wilde (1979) analysis. There is also substantial empirical analysisof the benefits of advertising in reducing prices: see Benham (1972); Steiner(1973); Marvel (1976); Cady (1976); Farris and Albion (1980); Kwoka (1984); andHaas-Wilson (1986). Indeed, this research has been cited by the U.S. SupremeCourt in providing some protection to "commercial speech" (i.e., advertising.)

Before proceeding, it is worth mentioning that in general the states do not doas good a job as the FTC in regulating advertising and deception. (Beales andMuris (1993); Muris (1991). State regulators often bring cases for politicalreasons, and anyway do not have access to the large staff of the FTC.Moreover, Beales and Muris (1993) point out that having multiple regulators islikely to lead to more restrictionof advrtising than is appropriate.

2.1 Lack of Availability

This is best discussed through an example. There have been recent attempts inthe U.S. to regulate advertising of prices of airline tickets on the grounds thatnot "enough" tickets have been available at advertised low fares. Cases such asthis will likely have the ultimate effect of raising prices paid by consumers byreducing incentives of sellers to advertise, and thus offer, low prices. The adsare true but allegedly incomplete. However, discouraging these ads is likely tolead to higher prices. New reservation systems are quite sophisticated andenable airlines to track reservations on each flight on a real time basis. If a flightis not selling as well as expected, it is possible for the airline to offer morediscounts on that flight. Thus, advertised low prices may be available only onan irregular basis. However, if consumers call and ask for such fares, travelagents will be able to determine which flights have low fares available. Ifadvertising of these fares is outlawed, then airlines will have reduced incentivesto offer such low rates.

2.2 Price as Information

The second argument regarding deceptive pricing is that consumers may bemisled about quality if they perceive price as a signal of quality. Firms have beenordered to reduce advertising of sales and specials for this reason. There are twoproblems with cases based on this argument. First, there is no persuasiveevidence that consumers are deceived by these ads. Second, there are largesocial costs from preventing this type of advertising, even if there is deception.

There is a substantial marketing literature examining the effects of price adson consumer expectations of quality. This is not an appropriate place tosummarize this literature, particularly as there are two recent summaries available.Both indicate that the results of the empirical literature examining this issue areat best inconclusive. Zeithami (1988, p. 2) says that: "...research on theseconcepts [price, quality, and value] has provided few conclusive findings."Similarly, Monroe and Krishnan (1985, p. 229) indicate that "We have not beenable to identify conceptually or empirically when buyers will infer productquality on the basis of price," and "Considering previous studies individually,it is troubling to find such inconsistency in the results across studies." Liefeldand Heslop (1985) and Blair and Landon (1981) find similar results. Thus, theevidence for the existence of consumer deception associated with priceadvertising is highly uncertain.

Even if some consumers are deceived by some comparative price advertising,the costs of limiting or forbidding such advertising are likely to be substantial.For example, consider the issue of the volume of sales which must occur at someprice before it can be advertised as the "regular" or "normal" price, a commonfeature of attempts to regulate deceptive pricing. A firm might engage inpredictable seasonal promotions, such as sales of tires or white sales ofhousehold furnishings. If consumers are aware that such sales occur, they willrefrain from buying except during the sale period. Thus, there will be relativelyfew units sold at "regular" prices, even though these prices may be commonlyavailable. In such circumstances, any attempt to limit advertising would haveone of two effects. The firm might be forced to offer less frequent specials sothat more items would be sold at the normal price, a course of action whichwould clearly harm consumers. Alternatively, it might cease advertising theregular price, but if, for example, this price is comparable to other prices in themarket, then consumers would be denied valuable information. Similarly, if a firmerrs in choosing a price, it might sell few items at that price, but restrictions onadvertising of reference prices might make it difficult to inform customers of thechange. [See also Muris (1991).]

Moreover, even if consumers are deceived, there is no evidence that they areharmed. In one experimental study (Urbany, et al. (1988) which did findconsumers deceived by price ads, it was nonetheless found that there was nomeasurable injury even to those consumers who were deceived. The authorsfound that there is some effect of even of unrealistic exaggerated prices and that"Consumers can be skeptical of advertised sale offers but can still be influencedby them." Nonetheless, even given this strong finding of deception, it was stilldetermined that there is "no significant difference between the ending bankbalances..." of subjects in groups with and without advertised reference prices.Bond and Murphy (1992) found that, averaged over all products, departmentstores using reference pricing had prices below the average of all competitors.

Interestingly, the authors attribute their results regarding deception in partto the fact that their subjects may have believed that it is illegal to exaggeratereference prices, and that the law is strictly enforced. This indicates thatincomplete enforcement of deceptive pricing laws may actually be harmful. Ifconsumers are normally skeptical of such ads, then they cause little if any injury.However, partial enforcement may lead consumers to overestimate the level ofenforcement and relax their normal skepticism. This will be particularly likely ifthere is wide publicity given to the few enforcement efforts which do occur. Thisis itself likely, given the political orientation of many state enforcement officials.

Schmalensee (1978) presents a model where there may be losses toconsumers from deceptive advertising, and where losses are greater asconsumers believe ads. Here we argue the converse: losses may be greater asconsumers believe that there is enforcement of rules against deception. Viscusi(1985) has found that consumers who believe that the government is enforcingsafety standards at a greater level than is true may be "lulled" into acceptinggreater risk, and it is plausible that similar results apply to advertising.

The basic problem with policies against deceptive pricing is that in generalit is discount firms and firms stressing price which engage in these promotions.As a result, any effort to limit such advertising is likely to lead to higher pricesin the market. As Robert Pitofsky (1977, p. 688), an advocate of rigorousenforcement of consumer protection regulations, has argued, "...as long asconsumers are accurately informed of the offering price, they can make sensibledecisions, and the transactions may still be at prices lower than could beobtained at most other outlets in the marketing area." Pitofsky views reducedenforcement of deceptive pricing claims as a gain for consumers. This isespecially true since the possible gains from such enforcement are doubtful andspeculative, while the costs are obvious and substantial.

3. Regulation and Types of Goods

A public authority charged with advertising regulation has a substantial amountof discretion. The nature of language is such that almost any claim could beinterpreted as being deceptive or misleading under some readings, so that thereare a large number of cases which could be brought [Craswell (1985)]. Moreover,most cases brought by the government are settled through consent decrees (anagreement by the firm not to engage in the behavior in the future), so that thereis little litigation over the issue of deception and the correctness of the agency'sposition is not tested in court. This may be because of the high reputation costto a firm from being named as engaging in "deception" [Peltzman (1981)].Mathios and Plummer (1989), generally find that firms which contest FTC ordersend up with greater capital losses than firms which consent without a contest. In this circumstance, it is important for regulatory officials to have a strongtheoretical basis for bringing some cases and not others. Economics providesthis theoretical basis. Economists argue that the basis for regulation should bethe effect of claims on consumer welfare, and economics provides a frameworkfor determining which types of ads are most likely to reduce consumer welfare.

Economic analysis indicates that there are three types of characteristics ofgoods with respect to advertising. These are called "search," "experience" and"credence" characteristics. For the discussion of search and experience goods,see Nelson (1970) and Nelson (1974). For credence goods, see Darby and Karni(1973). For applications to regulation of advertising, see Jordan and Rubin(1979), Saunders (1991), and Heald (1988). Search characteristics can bedetermined before the associated goods are purchased; an example is the colorof a suit. Goods must be purchased and used before experience characteristicscan be evaluated; an example is the cleansing power of a soap. For credencecharacteristics, the consumer may never know if the characteristic exists, evenafter purchase; an example is unnecessary repair to a TV (or unnecessarysurgery), for the TV (or the body) will work afterwards even if the repair wasunneeded.

Given this classification, some principles of regulation of advertising areinstantly apparent. First, for search characteristics, there is no need forregulation. Consumers can immediately determine if the good possesses theadvertised characteristic, and cannot be deceived. Moreover, since this is so andfirms understand that it is so, there is no incentive for deceptive advertising with

respect to these characteristics. Transaction price is a search characteristic (i.e.,consumers will know the transaction price before purchase), which is whyattempts to regulate advertising of transactions prices, discussed above, areunneeded and counterproductive. Second, for inexpensive goods, there is littlecost to deception with respect to experience characteristics. The consumer willbe deceived at most one time with respect to such goods, and therefore ingeneral losses will be small. In Schmalensee (1978) there are losses to consumersfrom deceptively advertised experience goods, with losses increasing asconsumers believe ads. Regulators should concentrate on relatively expensiveexperience goods and particularly on credence goods.

This analysis has additional implications. In particular, it points to theimportance of reputation as a protection against deception and to the importanceof advertising in generating a reputation [See Rubin (1990), Chapter 8].Economists had long been puzzled by apparently noninformative advertising.Nelson (1974) showed that in certain circumstances the very existence ofadvertising would itself provide information. Advertising would only beworthwhile if it led to repeat sales for experience goods, but firms could expectrepeat sales only if the product were of sufficiently high quality. Therefore, thewillingness of a firm to spend money on advertising would itself provideinformation to the market that the firm expected repeat sales because it believedthat its products were of high quality.

Problems of assuring or guaranteeing quality arise in many markets. Theproblem was first analyzed by George Akerlof in a famous article dealing with"Lemons." [Akerlof (1970)]. A lemons market is defined as a market which failsin that only low quality items are sold, even though consumers would be willingto pay high prices for high quality items. Three conditions are necessary togenerate a lemons market. First, consumers must be unable to determine qualitybefore purchase. Second, it is necessary that higher quality goods cost more toproduce than lower quality. Finally, there cannot be a credible way for a firm toguarantee quality. If these three conditions are met, then the market mechanismmay break down. This will happen because no firm will be able to convincinglypromise high quality items. As a result consumers cannot be sure of obtainingthe higher quality and so will not pay the higher price for quality items. Thus,even though consumers would be willing to pay a higher price in order to obtainquality, there will not be an effective way in which this desire can be satisfied.It is in this sense that the market may malfunction.

The lemons problem identified by Akerlof (1970) exists only if firms cannotconvincingly communicate to consumers the level of quality in their products.If firms can produce high quality products and convince consumers that theyare doing so, then the market failure disappears. There is a substantial literaturedevoted to the economics of information which demonstrates ways in whichmarkets can and do solve the problem [See Ippolito (1986)]. The implications ofthis literature for advertising regulation have not been fully explored.

Klein and Leffler (1981) explicitly related Nelson's discussion of advertisingto Akerlof's lemons problem. They showed that the mechanism identified byNelson and related mechanisms could be used to solve the lemons problem.Investments in nonsalvageable firm-specific capital (capital which would becomeworthless if the firm were to shut down) would serve to guarantee quality sincethe firm would lose the value of these investments if consumers dissatisfied withlow quality products forced it to shut down by withdrawing patronage. Inaddition to advertising (including endorsements by celebrities) such capitalincludes investments in establishing trademarks and brand names, and also inphysical assets, such as signs and decor.

Shapiro (1982) and Shapiro (1983) showed that firms could invest inestablishing a reputation for being quality producers and that what might appearto be excess profits would actually be a return on this investment.Generalizations of these results were provided by Allen (1984) and by Kihlstromand Riordan (1984). Milgrom and Roberts (1986) showed that the results wererobust to allowing price variation, and that in this situation price itself couldsometimes serve as an additional signal of quality. Lynch and his co-authorsprovided an experimental test of these models: Lynch, Miller, Plott, and Porter(1986). They found that it is possible to generate lemons markets in laboratorysettings, that truthful advertising will eliminate problems associated with suchmarkets and that reputations will sometimes serve to eliminate these problems.

Arguments regarding incentives to produce quality are routinely acceptedin the economics literature. For example Landes and Posner (1987 , p. 270)indicate that "Creating such a reputation [for high quality] requires expenditureon product quality, service, advertising and so on." This article also discussesthe importance of creation of property rights in trademarks and brand names. Itis only if such property rights are created that firms have proper incentives tomaintain quality.

Once it has been decided to confine regulation to particular types of ads andproduct characteristics, however, the problem is not solved. Any deceptive adwill deceive some and inform others. Therefore, a balancing test of some sort isrequired in order to determine if a case is worth bringing. Recently, an economicanalysis of deception has provided exactly this sort of balancing test: "Anadvertisement is legally deceptive if and only if it leaves some consumersholding a false belief about a product, and the ad could be cost-effectivelychanged to reduce the resulting injury." [Craswell (1985, p. 657) See alsoCraswell (1991)]. This criteria for deception essentially says that an ad isdeceptive only if the costs of changing it are less than the benefits. Included inthe cost of changing the ad is any information lost by those consumers whowere not deceived by the initial ad and who would find a proposed substituteless informative. This cost-benefit criterion is a useful guideline for exercise ofprosecutorial discretion, and a guideline based on an explicitly economicanalysis.

There have also been analyses of competitors suits leading to privateenforcement of remedies for deception under the Lanham Act. Jordan and Rubin(1979) are skeptical of the potential benefits of such suits. On the other hand,Saunders (1991) argues that in the context of claims regarding popularity of aproduct and claims regarding certain categories of credence goods competitorscould do a good job of policing. There have been many additional Lanham Actsuits since the empirical analysis in Jordan and Rubin (1979) and this is aninteresting area for further research.

4. Deception by Omission and Mandated Disclosures

So far, I have dealt with deception in the form of false statements. However, afurther class of acts which are sometimes viewed as deceptive are statementswhich are true but incomplete in some way which is viewed as material. For thesecases, regulatory agencies impose various remedies. Sometimes sellers are heldto commit "deception by omission." In other cases, there is some mandateddisclosure associated with an ad. These mandated disclosures may be required"across-the-board" for all advertising of a product, or may be "triggered" bysome claim [See Beales, Craswell and Salop (1981)].

An example of mandated disclosure is the set of warnings on cigarette packsand in cigarette advertising. These disclosures are across-the-board since anyad for a cigarette requires a health warning. Triggered disclosures aredisclosures required only if some other claim is made. For example, under theU.S. Truth in Lending statute, whenever a statement about down payments ismade, there must also be statements about the interest rate (Annual PercentageRate) and the number and size of monthly payments. Another example isprovided by the FTC "Funeral Rule" which required that funeral providers giveconsumers various types of information. In a study of this rule, McChesney(1990) found large costs and no measurable benefits.

While such disclosure remedies are common, economic analysis casts doubton their general utility. There is support in the literature for the hypothesis that,as long as explicit deception is forbidden, sellers have incentives to revealnegative attributes of their products, because otherwise consumers willrationally assume that an advertisement will omit a critical piece of information(say, the weight of a notebook computer) only if the value of that attribute forthat product is low. Thus, producers of products with quality levels above theminimum will have incentives to advertise this fact, and in the limit the marketwill provide complete information. The models which prove this result are quitegeneral, and the result seems robust. This result has been shown in Grossman(1981); Milgrom (1981); Jovanovic (1982); and Milgrom and Roberts (1986).Jovanovic (1982) shows that in many circumstances there will actually be toomuch information disclosed. Matthews and Postlewaite (1985) show that undersome circumstances mandated disclosure laws will induce firms not to test theirproducts for quality.

An example is the advertising of tar and nicotine content of cigarettes [Calfee(1986)]. In the 1950s (and perhaps earlier) consumers began to fear the healtheffects of smoking, and began to believe that tar and nicotine were undesirable.(The process described here generally requires at least some consumerinformation regarding the negative characteristic. However, regulation is unlikelyto occur in an environment where there is a total lack of such knowledge.) As aresult, cigarette companies began to advertise the levels of tar and nicotine, withthe advertising being stimulated by those brands with the lowest levels. Theprocess was greatly slowed down in 1959 when the FTC virtually stopped suchadvertising. Nonetheless, there was a substantial incentive for advertisers topublicize the negative aspects of their products, as long as some brands had lessnegative characteristics than others.

From a theoretical perspective, the process of advertising negativecharacteristics is the obverse of the lemons problem, discussed above. In alemons market, information is not verifiable, and as a result only low qualityproducts are sold because sellers cannot convince buyers to pay for highquality products. The process discussed in this section requires some form ofverification, but the theory indicates that if there is some method of checking onclaims, then sellers will offer complete information about both high and lowquality products. Indeed, the analysis is just the mirror image of the lemonsanalysis. That analysis shows that if the lemons problem can be solved, sellersof high quality products will have incentives to reveal that their products areindeed of high quality. But this means in the limit that any seller of a productwhich is of any quality above the minimum will indicate quality. Consumers maythen assume that any product which does not disclose quality is of minimumquality, and the informational problem is solved.

In making policy with respect to disclosure, it is important to distinguishbetween equilibrium and disequilibrium situations. At equilibrium, there will bea substantial amount of disclosure in markets. However, many interesting policyissues occur in periods of disequilibrium. The disequilibrium may be with respectto advertising, but it may be in terms of actual product characteristics as well.Advertising affects sales at current prices of existing products. It also influencescharacteristics and prices of products which firms will offer in the future.Advertising changes future product characteristics because a firm will onlyproduce products or establish prices that it expects to be able to advertise. (SeeCalfee and Pappalardo (1989) for a discussion in the context of health claims.)

An example is the introduction of Nutrasweet (aspartame) into diet softdrinks. Initially, diet products used a combination of saccharin and aspartame,and advertised "Now Contains Nutrasweet." Some states believed that this claimimplied the products had no saccharin, and would have stopped the advertising.The FTC, however, did not do so. Rather quickly, other drinks began to useNutrasweet exclusively, and advertise that fact. Now, virtually all drinks use onlyNutrasweet. Thus, the ability to advertise Nutrasweet during the transition wasessential to reaching the new equilibrium.

A disequilibrium is likely in a market which has changed in some way.Possible changes are in product characteristics, in information about products,or in consumers' tastes. Because there has been some change, existing productswill not perfectly satisfy consumers' desires. Nonetheless, producers of thoseproducts which are closest to satisfying new desires will have an incentive toadvertise this fact. In such circumstances, some advertisers may initially offerpartial information to consumers. At some point other advertisers will competeby offering more complete information, and others may compete by furtherchanging the product to reflect changed tastes. The ultimate equilibrium willoccur with relatively full information and with the optimal set of products beingoffered. However, if the process is stopped because regulatory authorities thinkthat the partial information is deceptive, then the full information equilibrium willnever be reached, and the best set of products may not be sold. Moreover,information useful during the disequilibrium period may be different frominformation needed once the new equilibrium is reached. Disclosurerequirements based on information needed in the disequilibrium may simplyimpose costs with no benefits once the equilibrium is reached.

A good example is the history of advertising of the fiber content of breakfastcereals. [Ippolito and Mathios (1990)]. This advertising was contrary to theFDA's policies regarding advertising of health claims in foods. Nonetheless,once the advertising began, cereals with higher fiber content increased sales,and new cereals with increased fiber were marketed. Moreover, during the sameperiod, levels of sodium and fat in cereals also decreased. Advertising did a moreeffective job of spreading this information to consumers than had governmentalattempts at communication.

Another example of a change in product characteristics caused byadvertising is cigarette advertising, mentioned above [Calfee (1986)]. Whenadvertising began, tar content of filter cigarettes was virtually no lower than forregular cigarettes. Nonetheless, over a short period (1957-59) as a result of heavyadvertising of tar and nicotine content, levels (weighted by sales) fell by 40%.The first cigarettes to advertise had perhaps only marginally lower tar levels thanother brands, and when regulators looked at this advertising they ultimatelystopped it as being deceptive. The long run effect of the advertising before itwas stopped was to actually change product characteristics. As sellerscompeted by advertising tar and nicotine levels, some producers found itworthwhile to reduce levels in order to be able to advertise lower amounts. Otherfirms responded, and the ultimate result was reduced levels of tar and nicotine.The benefits to consumers of this dynamic effect of the advertising greatlyoutweighed any potential harmful effects from any alleged initial deception.


5. Regulation of Health Claims

In order to evaluate regulation of health advertising (and particularly advertisingof prescription drugs) it is necessary to first look at the effect of the advertising.Leffler (1981) examined prescription drug advertising and found that it informedphysicians about the effects of superior new products but also created somebarriers to new entry by later competitors. Nonetheless, he found a beneficialeffect of advertising and promotion. Hurwitz and Caves (1988) find similarresults, and conclude that a law making entry by generics easier should lowerthe barriers to entry created by advertising of established brands. Rubin (1994)found that there was no evidence of deception in pharmaceutical advertising.

The FTC generally allows any advertising which is truthful, with only a fewexceptions, such as mandated disclosure, discussed above. The FDA, on theother hand, greatly restricts even truthful advertising, including advertising oftrue claims for prescription medicines. Presumably it is for the same reason thatthe agency is excessively cautions in approving new drugs [Peltzman (1973)]. Ifa direct to consumer print ad for a prescription drug mentions both the name andthe use of the drug, it must also provide an extensive discussion ofcontraindications and side effects. These disclosures are commonly pages ofsmall print. As a result, prescription drug ads often indicate either the name ofthe drug (usually for price comparison purposes) or that one should "See yourphysician" for some unnamed treatment for particular symptoms, although someads do contain the complete set of warnings in small print. TV ads forprescription drugs were until recently effectively forbidden by the disclosurerequirements. There are both health and economic benefits to be expected fromprescription drug advertising, and the FDA does not pay sufficient attention tothe benefits from promotion [Masson and Rubin (1985), and Masson and Rubin(1986)].

In addition to providing health benefits, increased advertising would lead tolower prices for prescription drugs. Advertising could inform consumers ofsubstitution possibilities and thus put pressure on prices. As of now, manyretailers advertise prices of drugs by name, but they cannot indicate the use ofthe drug. Some consumers may recognize that the advertised drug is the one thatthey are taking, but others will not and will not be able to benefit from the lowprices. For some studies of the effect of advertising on prices, see Benham(1972); Steiner (1973); Marvel (1976); Farris and Albion (1980); Kwoka (1984);and Haas-Wilson (1986). (See also the references in Section 7 regardingadvertising by attorneys.)

The FDA has advertising jurisdiction over some aspects of nonprescriptionor over-the-counter (OTC) drugs and also over some aspects of foodadvertising, particularly with respect to health claims. The FDA is sometimesunwilling to allow true claims about even OTC drugs. It is continuing its policyof discouraging truthful advertising of the large effects of aspirin in reducingheaSrt attacks, in spite of overwhelming scientific evidence about the truth ofthis claim and evidence that physicians do not communicate this benefit topatients. [Keith (1995)] The FDA also generally requires prior approval of thesubstance of many advertising claims. Beales (1994) discusses the costs andbenefits of this prior approval in the context of unapproved uses for prescriptiondrugs that are marketed for other uses, and finds that the costs are greater thanthe benefits. In recent years, the FTC, which shares jurisdiction in a complex waywith the FDA, [discussed in Calfee and Pappalardo (1989) and in Beales (1994)]has suggested more leniency in allowing true advertising claims than has theFDA. Part of this disagreement is because economists at the FTC focus onbenefits as well as costs of advertising and therefore are more likely to advocateallowing true claims.

An issue which arises in discussing "true" claims is the standard of truth.Many claims about product characteristics are uncertain and their validity isprobabilistic. Many health claims are of this sort: it is not certain whether or notsome claim is true. The proper standard of proof in this case is a cost benefittest. That is, health claims would be allowed if the expected value (in terms ofhealth outcomes) is positive. If there is some chance that a drug might save livesand if it has relatively insignificant side effects, then a claim might be allowedeven if there is a relatively small probability of its being true. The FDA oftenseems to require a higher standard, under which a claim would not be allowedunless there were perhaps a 95 percent chance that it is true. This would denyconsumers much valuable information [Calfee and Pappalardo (1989)].

Urban and Mancke (1972) discuss federal regulation of aging claimsregarding U.S. whiskey. They show that the regulation (which required thatwhiskey be aged in new, rather than reused barrels in order to claim to be"aged") had the effect of benefiting manufacturers of barrels, producers oftraditional U.S. "heavy" whiskey, and importers, and harming producers of U.S.light whiskey and consumers.

Schneider et al. (1981) show that the 1971 ban on cigarette advertising ontelevision in the U.S. did not reduce and may have increased cigaretteconsumption, but that information regarding the risk associated with smokingdid lead to long term reductions. Mitchell and Mulherin (1988) find that the banled to an increase in stock prices of cigarette manufacturers, presumably becausethe ban made entry more difficult.

6. Advertising by Lawyers

There have also been explicit studies of advertising by attorneys. The FTCfound that whenever there was a significant difference in price of a particularlegal service as a function of advertising restrictiveness, prices were higher incities where there was greater restriction of advertising. [Jacobs et al. (1984)]. Seealso Cox et al. (1982), and Calvani et al. (1988). Hudec and Trebilcock (1982)discuss the case of Canada and also suggest much less regulation than has beentraditional.

The organized bar has historically favored advertising restrictions.Advertising by attorneys provides benefits to consumers and to someattorneys, but overall attorneys lose money from such advertising. Posner, forexample, indicates that advertising is more important for new entrants and thatprohibition of advertising is a part of the traditional attorney cartel. [Posner(1993)] That such bans on advertising are consistent with the self interest ofattorneys is obvious from the FTC Study, which shows that reduction onrestrictions on advertising lead to lower prices for attorney services. Theevidence indicates that "legal clinics" offer higher quality service than traditionallawyers. [McChesney and Muris (1979); Muris and McChesney (1979)]. Thegeneral issue is also discussed in McChesney (1985) and the Supreme Courtcases are summarized in McChesney (1996).

7. Remedies

Some remedies for deception which have been used or proposed are, inincreasing order of severity, cease and desist orders, corrective advertising,consumer redress, and fines. In order to evaluate these remedies, it is useful toset forth a theory as to the goal of the remedy. The ultimate goal is of coursemaximization of consumer welfare and this can be achieved if it does not pay forfirms to engage in acts which are likely to lower welfare. Policies should thereforebe aimed at making sure that harmful acts do not pay.

What is relevant is that a remedy provide the correct amount of deterrence.For the types of activities discussed in this paper, it is possible to have eitherunderdeterrence or overdeterrence. Underdeterrence is the situation in whichwhatever penalties exist are too low, so that too much deception occurs.Overdeterrence occurs when penalties are too high. While it may appear that itis impossible to have "too little" deception, it is nonetheless possible tooverdeter deceptive advertising. This is because, as indicated at many points inthis paper, the line between deception and useful information is not always clearand one result of overdeterring deception through excessive penalties would bethe suppression of provision of information that many consumers will finduseful. On the general issue of optimal deterrence, see Becker (1968); Posner(1993), Chapter 7; and Polinsky and Shavell (1979). For an application based onthe FTC see Nash (1991). For a discussion of overdeterrence of "white collarcrime" see Rubin and Zwirb (1987). Advertising is discussed at pp. 904-905.

The traditional FTC remedy for deception was a cease and desist order whichrequired the firm to stop the offending ad. In general, such orders includelanguage forbidding the practice in question in the future, and are enforced byfines. This remedy appears relatively mild and therefore unlikely to overdeter,although there is evidence dealing with the stock market effects of these orderswhich indicates that they may be much more costly than is apparent [Peltzman(1981); Mathios and Plummer (1989)]. This may be in part because such orderscontain "fencing in" provisions that may apply to additional advertising forother products or claims, although the capital market effects are still larger thanseems reasonable. The Magnuson-Moss FTC Improvements Act of 1975 hasgiven the Commission broader powers, including the power to enforce rules withmonetary penalties and also the power to seek redress for fraud under somecircumstances. [For a discussion of FTC remedies, see Muris (1991)]. TheCommission has relied heavily on the theory of optimal deterrence in computingfines, and the economists are deeply involved in these computations.

For most deception cases, the Commission still relies on cease and desistorders. In most cases, this is the appropriate remedy. As indicated above, adetermination that an ad is deceptive is difficult, and many ads may beinnocently written and later interpreted as being deceptive. Even when usingtheir best efforts, firms will sometimes err and produce an ad which is later heldto be deceptive. Since this is so, any penalties more severe than an order to stopcould easily cause firms to reduce the amount of potentially actionable materialin their ads; this would be done by simply reducing the information content ofthe ads, and relying instead of puff or image advertising.

Another remedy is "corrective advertising", requiring the advertiser to payfor advertising to counter the deceptive advertising. This remedy may beinappropriate since most evidence indicates that the effects of advertising areshort lived [Ehrlich and Fisher (1982); McAuliffe (1987, p. 69); Thomas (1989)]and therefore the effects would likely have dissipated before the corrective adwould appear. The only purpose of a corrective ad would therefore be additionaldeterrence, but if desired this can be achieved more efficiently through directmethods. Heald (1988) discusses remedies in private civil suits where the courtshave ordered losing defendants to pay large damages based on the cost to thedefendants of the deceptive advertising, in theory to be used by winningplaintiffs to finance corrective advertising. He finds these payments excessive,leading to overdeterrence. Singdahlsen (1991) is also concerned withoverdeterrence.

The FTC has powers to name advertising agencies as well as advertisers incomplaints for deception. If agencies have skills in assuring that ads are notillegally deceptive, then finding them liable would seem to increase the ability ofthe Commission to deter deception. However, advertisers have contractualagreements with agencies. Therefore, if advertisers want agencies to help themcomply with the law they can contract for these services, as shown in the Coasetheorem. It would even be possible for an advertiser to contract with an agencyfor indemnification by the agency in the event of liability. More generally, itwould not be efficient for agencies to determine the truth or degree ofsubstantiation for each ad they produce. Imposing liability would increase thecosts of advertising since agencies would be forced to make an independentinvestigation of each ad.

For those acts which are to be punished by a fine, it is important to use thecorrect fine. First, it is appropriate to restrict the use of fines to true fraud(deception where the firm is consciously attempting to deceive) since thisreduces the chances of overdeterring provision of true information. Second, thecorrect fine is one which is just equal to the (expected) harm caused by thedeception. Such a fine will provide firms with the correct incentives. Since somewho engage in deception will not be caught, the actual fine must be greater thanthe observed harm for those who are detected. If, for example, one offender ofthree is detected, then the fine must be equal to three times the harm caused bythose who are punished. In this case, the probabilistic value of the fine tosomeone considering violation will just be equal to the harm his act will cause,and the result will be that firms will not undertake acts which impose net harmson consumers. As indicated above, this is the exact goal of deterrence. (For adiscussion of computation of probabilities, see Feinstein (1990) and Nash(1991).) Altrogge and Shughart (1984) found that FTC fines in advertising casestransfer money from small to large firms, consistent with the literature on rentseeking.

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