The Economic Theory of Mediocrity

 

I was having some work done and the man who I'd hired stated, "Mediocre work is the bane of this industry. Consumers are too ignorant to know quality work. It is not that they are stupid. They simply do not have enough experience to know quality work from mediocre work, until it is too late."

This very intelligent tradesman, really a superb craftsman is a better description, summed up an economic theory outlined in an article by Carl Shapiro ("Consumer Information, Product Quality, and Seller Reputation," The Bell Journal of Economic, Vol. 13, No. 1 (Spring 1982), pp. 20-35.) In this article, Mr. Shapiro analyzed the markets where consumers are not perfectly informed about product quality.

This tradesman, who takes enormous pride in the quality of his work, for which he was rated the best in the U.S. at one point, went on to say he once asked a well-known person in his same field how in the world he was able to complete so many jobs in any given month or year. The man stated, "Consumers do not know the difference between your work and mine. If I can take short cuts and complete three times more projects than you, but price my work 25% less than yours, I get the advantage of a much higher profit margin than you (and higher than I deserve) plus I get the volume. The consumer never knows the difference because they don’t know what the differences are."

Listening to this craftsman telling his story, I was thinking:

  1. He really should be teaching a college level economics/marketing class. He is well spoken and has real world application.

  2. He can determine, with some accuracy, the value of cutting corners and taking advantage of consumers.

  3. His problem is my problem. His problem is all my insurance agency clients who really care about the craft of providing clients with the right coverages and solutions problem. It is the same everywhere.

 

His frustration was boiling over and I can commiserate because I often feel the same frustration when I see insurance agents hire other consultants who charge as if their product was quality, and it is not. The agents do not know the difference because maybe they only purchase the service once or twice in their careers making them easy targets for more conniving "consultants."

I never learned about Shapiro's analysis in college even though I took numerous economic courses. I did not learn about it in my master’s program either (possibly a victim of Shapiro's analysis here too?). I learned about it in a book, Phishing for Phools, The Economics of Manipulation & Deception, by the brilliant and Nobel prize winning economists George Akerlof and Robert Shiller. I almost hate sharing this information because there are readers that might use it to take further advantage of the true coverage experts.

In their book, they use Shapiro's analysis to describe how the public, governments, and other financial institutions were taken advantage of by financial institutions that used/abused the rating companies. In their book, they used the example of avocado farmers. Let's say that an avocado rating entity exists.

Historically, they rated the quality of avocados as AAA, AA, A, BBB, BB, B, C. These six ratings from best to worst. Most consumers can't tell the difference between a AAA, AA, A, and maybe a BBB avocado, but historically, the avocado rating company did a pretty good job making the distinctions enabling avocado farmers to charge more for the highest quality without taking advantage of consumers. (Think bonds, securities, derivatives, insurance companies, etc.) Then this one farmer develops this new kind of avocado that looks like an AAA old-fashioned avocado. It has the same feel, texture, and taste--at least at the moment it is being graded. You see, the farmer figured out how to grow an AAA avocado that was an AAA avocado within the small time frame he knew it would be graded. But since it did not last, it did not deserve the rating. The rating companies only looked at it for one moment. They did not have the complex analytical tools to see they were being taken advantage of. The consumers couldn't tell the difference at the store either so they relied on the ratings provided and since it is cheaper to grow avocados that don’t last, they liked the high quality (they thought) with the lower price.

The corner cutting farmer will then outsell the quality farmer causing the quality farmer to sell out or cut his quality to compete, unless somehow he can convince consumers there is a difference (they can't easily see) between his quality product and the mediocre product. As Shapiro described his analysis in 1982, this is always going to be a problem in free markets. The sharks will take advantage of those who take pride in their quality and consumers, all day, every day provided the consumer can’t tell the difference until it is too late (picture the credit crisis and purchase of horrible financial products that were graded AAA because neither the rating companies, much less the consumer--even those these were sophisticated consumers--could tell the difference).

Shapiro's analysis is at the heart of my craftsman's frustrations, and quality insurance peoples’ frustrations everywhere. How has this situation developed in the insurance industry? Pretty much the same way it develops everywhere. Where before trust played such a key role, trusting relationships have become less important. To some extent this is a carrier-agency issue. Carriers used to truly care more about the quality of their agents (at least some did). Not so many care about quality today unless it decreases their cost.

Predictive modeling is one facet whereby trust is less important because predictive modeling can, in theory, address the advantages trust used to provide and do so more cheaply. Whether it does or does not is a moot point because even if it fails, the horse will be long gone out of the barn, just like Shapiro's analysis predicts. Corner cutters and worse look for situations in which quality cannot be determined until long after the sale is made.

This is why the authors titled their book, Phishing for Phools, The Economics of Manipulation and Deception. It is my position the insurance industry has always suffered reputational issues because the product is complex, the consumers' ability to understand the complexities are minimal, many sellers of insurance do not understand the complexities themselves, and quite a number of insurance sellers are willing to take advantage of consumers. Unfortunately the P&C industry has always had those brilliant sellers advising clients "You only need 80% coverage on your building" leading the consumer to believe that somehow, someway, 80% = 100% and the price was cheaper. Shapiro's analysis in action because the consumer does not understand 80% does not equal 100%. Can't be simpler than that.

Today though, we have a new level of marketing genius within many new insurance companies and agencies selling insurance that looks great to consumers upon purchase but is rather hollow, especially hollow if any kind of crisis/catastrophe occurs. The coverages simply do not exist. Another model, sometimes separate and sometimes related, is arguably the capital does not always exist but they have figured out how to get their ratings without the public understanding the difference between shareholders providing the surplus and the consumer providing the surplus themselves. The pressure is intense to decrease quality to mediocre.

 

Another pressure point is all the acquisitions that have occurred because with those debt loads, quality will suffer and anecdotally, does suffer.

Truly only one solution exists for those who want to maintain their quality and stay in business. That solution is complex. Beware of those selling simple solutions (my bane of consulting existence are others selling simple consulting solutions to agents that just can’t tell the difference). In summary, the solution must entail:

 

  • Selling a trusting relationship in reality, not just advertising, rather than insurance.

  • Identifying a means by which you quit competing against mediocre. To compete directly against these entities when selling complex products, especially complex financial products, is simply a race to the bottom. You have to completely change the game.

  • You have to sell versus market. Marketing really is about transactional sales whereas selling is about building relationships one at a time. Marketing is essential to mediocre because it requires creating a false sense of quality on a mass scale. You must counter this by building a true sense of quality the hard way, one customer at a time.

  • You have to tell people your story, over and over and over. So many quality producers just expect consumers to realize the quality of their service/product but this is not reality. People are not going to initially understand the difference. The situation really is no different than if I was to buy a cheap wrench. I can't tell the difference until I use it. Then when I use it to try to fix something that is broken, I discover it rounds off the nut edges and compounds my problem. The same goes for an insurance solution. Until they have a claim, they may not know the difference on their own. You must tell them if you want them to value you before they have a problem.

 

These four points also require really knowing your coverages but also knowing how to apply them intelligently. Insurance education is subpar today (Shapiro's analysis at work again). I created a new program that is not education as you know it and my goal is to create, as I have, long-term relationships with people to provide ongoing, customized and real world practical knowledge that my clients' clients will appreciate, resulting in higher sales and lower E&O exposures.

Which side of mediocrity are you on? Will you provide quality services and help your clients understand that quality? Or, will you take advantage of your clients by selling "good looking" coverages that in reality fall far short of quality coverage?

NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information. 

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