A REFUTATION OF THE CHARACTERISTICS THEORY OF QUALITY PETER BOWBRICK ABSTRACT This is a formal refutation of the characteristics approach to the economics of quality, which is particularly associated with Kelvin Lancaster. Many of the criticisms apply equally to other approaches to the economics of quality. Copyright Peter Bowbrick, [email protected] 07772746759. The right of Peter Bowbrick to be identified as the Author of the Work has been asserted by him in accordance with the Copyright, Designs and Patents Act. ABSTRACT Lancaster‟s theory of Consumer Demand is the dominant theory of the economics of quality and it is important in marketing. Most other approaches share some of its components. Like most economic theory this makes no testable predictions. Indirect tests of situation-specific models using the theory are impossible, as one cannot identify situations where the assumptions hold. Even if it were possible, it would be impracticable. The theory must be tested on its assumptions and logic. The boundary assumptions restrict application to very few real life situations. The progression of the theory beyond the basic paradigm cases requires restricting and unlikely ad hoc assumptions; it is unlikely in the extreme that such situations exist. All the theory depends on fundamental assumptions on preferences, supply and characteristics. An alternative approach is presented, and it is shown that Lancaster‟s assumptions, far from being a reasonable approximation to reality, are an extremely unlikely special case. Problems also arise with the basic assumptions on the objectivity of characteristics. A fundamental logical error occurring throughout the theory is the failure to recognize that the shape of preference and budget functions for a good or characteristic will vary depending on whether a consumer values a characteristic according to the level in a single mouthful, in a single course, in a meal, in the diet as a whole or in total consumption, for instance. Many of the criticisms raised apply strongly to other approaches to quality. The alternative approaches developed here, to preferences, prices and different characteristics and goods spaces, can fit into some other approaches to quality. They permit more accurate and more realistic specification of models. The criticisms are original, apart from some previous criticisms of over-restrictive boundary assumptions in Lancaster. The alternatives presented are new. A Refutation of Characteristics Theory Peter Bowbrick THE IMPORTANCE OF QUALITY Quality plays a role in most transactions. It is an important determinant of prices. Today, quality is one of the main elements in competition. Both firms and nations compete not just on price but on their ability to produce good quality products and services. The importance of this in the USA and Britain has been shown by Wong, Saunders & Doyle (1988), Garvin (1988), Ouchi (1981) and Jacobson & Aaker (1987). In the food industry it has been particularly noticeable that the supermarket chains which survived the cut-throat competition of the last 25 years have been those that gained a reputation for quality, particularly in fresh foods, rather than those that aimed at low prices. This has had profound effects on the farming industry, on competition within the sector and on what people eat. THE OBJECTIVE OF THIS REFUTATION This refutation sets out two closely related hypotheses to be tested: 1. Lancaster‟s characteristics approach to the economics of quality is correct. 2. Lancaster‟s characteristics approach to the economics of quality is useful in the economics of the real world. The expected outcomes of the testing procedure are one of the following: - The theory survives unscathed, and as a result we can have more confidence in it. - The theory survives unscathed, being internally consistent, but is shown to have little or no practical application within real-world economics, and must be discarded. - The theory is shown to be weak in some aspects, but to survive the testing elsewhere. In this case the value of the theory is increased by recognizing and removing the weaknesses. It may be possible to repair the damage with new theory for instance. - The theory is shown to have limited application within real-world economics, but to survive testing within that application. The value of the theory is increased by recognizing this limitation, and not attempting to apply the theory where it has no application. 1 1. How and Why to Refute Peter Bowbrick - The theory is logically incorrect, and must be regarded as refuted. In the remainder of this chapter first the justification for testing Lancaster‟s theory is explained then the methodology for testing the theory is set out. LANCASTER’S THEORY OF QUALITY It is difficult for anyone working on the economics of quality to ignore Lancaster‟s theory of quality in consumer demand. It is probably the most influential theory of consumer choice of quality in the economic literature and it is also very influential in marketing. It is the most cited theory in the literature - over 1500 citations - and has reached that stage where it is used without being cited. It is used in applications relating to a wide range of goods and services. The theory was presented in two papers and two books (Lancaster 1966, 1971, 1975, 1979).1 The basic assumptions and logic are shared to a greater or smaller extent by other economic approaches to quality, and most other approaches share some aspects of the theory. This means that any weaknesses or limitations identified in Lancaster‟s theory have implications elsewhere. The theory is probably the most rigorous and the most fully presented of the economic approaches. That is to say he is less likely to omit important assumptions and distinctions than other economists. It also means that his theory is harder to attack. The theory is based on economic man. It builds up from assumptions about individual consumers to conclusions about market supply and demand, rather than being either based on empirical findings about individuals or operating at market level only. Its fundamental assumptions are to do with: 1) the nature of preferences: it is assumed for example that the indifference curves for characteristics have the properties of the familiar indifference curves for goods, 2) the nature of supply: it is assumed that the consumer has to pay more to get 1 Lancaster, K.J. “A new approach to consumer theory”, Journal of Political Economy, 74, 132-157. 1966. Lancaster, K.J. Consumer demand : a new approach. New York. 1971. Lancaster, K.J. “Socially optimal product differentiation”, American Economic Review. [September] 99-122. 1975. Lancaster, K.J. Variety, equity and efficiency. Columbia studies in Economics No. 10. New York and Guildford. Columbia University Press. 1979. 2 A Refutation of Characteristics Theory Peter Bowbrick more of a characteristic and that he or she can get more by paying more, 3) the nature of quality: it is assumed that quality is in the mind of the consumer, that individuals see the same objective characteristics in a good, but value them differently. Lancaster‟s theory provides a “construct paradigm”, in Masterman‟s (1970, p.65) classification of Kuhn‟s (1962) twenty-one uses of the word paradigm. That is to say it may be seen as an actual textbook or classic work, as supplying tools, or as actual instrumentation. The paradigm he provided has not been altered or replaced by a better form in the same tradition, though of course many completely different theories have been presented. It is unusual for a paradigm to survive unmodified for so long (see Kuhn, 1962 p.10), without being replaced by an improved, richer form, and this is an indication of the quality of Lancaster‟s presentation. Lancaster‟s popularity appears to derive from the following: 1) The analysis is presented rigorously, based on assumptions which are usually made explicit. This analysis is set out at some length. 2) The theory is presented clearly. 3) Lancaster shows his integrity by pointing out limitations in his theory and making explicit assumptions where he feels it necessary. 4) The theory uses objective characteristics rather than perceptions and beliefs. This gives the promise of “hard” results. It is also very much cheaper to work with easily measured characteristics than it is to identify and measure consumer perceptions. 5) The theory has a strong resemblance to economic theory which has proved successful elsewhere, like linear programming for least cost diets. It also makes use of familiar theory, on indifference curves for instance. Lancaster‟s approach is one of several with a close family resemblance. Theories presented by Becker (1965), Muth (1966), Ironmonger (1972) and Gorman (1956/1976) are also so close that they are generally treated as the same theory in so far as they deal with quality. Other theories such as those of Rosen (1974), Houthakker (1952), Thiel (1952) or Ladd and Zober (1977, 1979) share many of the same basic assumptions. These are discussed in detail in Chapter Four. THE REAL-WORLD ECONOMICS APPROACH The refutation will examine Lancaster‟s theory from the perspective of real-world economics. The most important requirement of real-world economics is that any theory it uses has to be operationally usable in the economic analysis of real-world production and marketing. Some theory which would be acceptable elsewhere is clearly inappropriate or largely irrelevant in real-world economics. This unacceptable theory includes economic analysis that is based on assumptions clearly 3 1. How and Why to Refute Peter Bowbrick irrelevant to real world problems, and economic analysis that is excellent for analysing other markets, but is largely irrelevant to agriculture. Agricultural products tend to be more variable than industrial products, so uniformity is achieved by classification and sorting, rather than by tight control over process and quality assurance.