Wednesday, October 11, 2006

The Peculiar Economics of Ratings

Recently, Michelin released a new Red Guide for San Francisco. For those who are not foodies, Red Guides are Michelin’s ratings for restaurants and hotels. Their hotel ratings tend to be ignored, while the restaurant ratings are the subject of a great deal of interest and speculation, particularly in France, where the addition (or worse yet, removal) of a “star” can make or break a restaurant. The Michelin guide also raises some interesting economic questions. The peculiar economics of ratings systems has two sides—the consumer side and the supplier side.

Consumers use published ratings as an information-gathering mechanism, a way of economizing on the costly actions associated with determining the quality of a product that they wish to purchase and consume. This is especially true for goods characterized as experience goods--that is, goods for which the consumer cannot easily ascertain the product’s quality prior to purchase. It's also true for durable goods like cars, or for goods that can only be purchased once, like a college education.

The more expensive a good is, the more incentive a buyer has to invest in information gathering. A meal at the local diner may not warrant the time, money, and effort needed to determine the restaurant’s rating. For a trip out of town or a visit to an upscale restaurant, such an investment may be useful, especially because it can help to reduce the risk of a disappointing experience.

Consumers want clear, objective information from a ratings guide. Advertising cannot convey the same kind of information, since it is (appropriately) perceived to be self-serving. Yet, how much faith can we place in the (presumed) objective information from ratings services, like Michelin or the Zagat’s? Is there a potential problem with these ratings guides that can affect the quality of the information they produce?

Sellers clearly can benefit from a favorable rating in these guides--for many restaurants, it can mean a significant boost to their revenues and provide an avenue to other revenue sources (a great rating could pave the way for the chef to write a cookbook, or these days, have their own TV show). Such a system may create perverse incentives for restaurateurs. A restaurant could alter its menu offerings, change the décor, or upgrade the wine and beverages list to improve their rating, but these changes may change the qualities that originally contributed to the restaurant’s popularity among consumers. Further, this can contribute to a restaurant version of an “arms race” to be the top-rated restaurant in a given city. This may be trivial, but the same logic applies to all sellers who compete for ratings rather than consumers. It is not as trivial, for example, in the case of colleges and universities who expend resources to boost their US News rank, or in the case of schools and teachers who “teach to the test” as opposed to teaching valuable academic skills.

1. What determines how much consumers are willing to spend on a restaurant guide for a city? Would this differ between local residents and visitors?

2. How do consumer ratings differ from advertising? When could advertising provide more useful information than a ratings guide?

3. Some people decry products that are supposedly shaped to win the favor of critics; a great example of this is that many people argue that winemakers produce wines to appeal to the tastes of the powerful wine critic Robert Parker. What’s the flaw in this logic?

4. Whose ratings are more valuable—those of expert reviewers like Michelin or the accumulation of opinions from regular diners?

5. When the Michelin ratings were published, many in San Francisco objected to the rankings. Some commentators argued that the taste of the Michelin writers was different than the taste of Californians. Since not everyone's preferences are the same, does it make sense for there to be one "accepted" ranking system? Would your answer be different if the good in question were surgeons rather than restaurants? Why?

Harold Elder is a Professor of Economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's Masters and Ph.D. programs.

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