Regulating Deceptive Advertising: False Claims and Skeptical Consumers

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Nowadays firms often claim that their products are superior, but product statements may not be truthful. Knowing firms’ potential dishonesty, consumers are skeptical about these possibly false statements and may investigate. To protect consumers, regulators can penalize firms who deceive consumers. In response to consumers and regulators, firms can make their false claims deceptive to impede investigation. We develop a game theoretical model to study interactions between dishonest firms, skeptical consumers, and regulations. We show that increasing the penalty for false statements can surprisingly reduce consumer surplus, firm profits, and social welfare. The welfare reduction is due to higher spending on deceptiveness, which hinders consumers from investigating potentially false claims. The lack of information discourages consumers from identifying product quality, thus decreasing welfare. Furthermore, when it is costless to adjust the penalty, the optimal penalty that maximizes both consumer surplus and welfare is the minimum penalty that ensures truthful claims, and it increases with firms’ quality difference and the probability of encountering a high-quality firm. In an extension, we allow regulators to detect false claims through consumer complaints. We find that higher penalty leads to lower consumer surplus if and only if the average product value is sufficiently high.

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