Are restaurant awards a negative signal?

I've been thinking about this for some time. If you are at a restaurant, and you spy a bunch of award certificates on the wall, should this give you confidence that this is a good restaurant? Many people would say 'yes, of course'. It is an award-winning restaurant, so of course it is a good restaurant. I'm not so sure, and in fact I think that in many cases a bunch of restaurant awards on the wall might be a negative signal, or no indicator at all. Let me explain why.

First, let's consider why restaurants need to signal at all. Restaurant quality is what economists call private information. The restaurant operators know whether their restaurant is high quality or not, but the patrons do not know (at least, not until they have eaten there). Restaurant meals are an experience good - the quality of the restaurant (an experience characteristic) is only known to the patron after they have experienced the restaurant meal. This information asymmetry between the restaurant operators and restaurant patrons creates an adverse selection problem. If high-quality restaurants can't distinguish themselves from low-quality restaurants, then the restaurant patron will assume that every restaurant is a low-quality restaurant (this is a pooling equilibrium). If this was to happen, then high-quality restaurants would probably start to close down (because they won't be able to get enough additional patrons to pay for their higher costs), and we'd be left with only low-quality restaurants left.

Of course, that scenario doesn't play out in most cities. Restaurants have found ways to make their quality known to patrons. When the informed party (the party that doesn't know the private information) tries to credibly reveal the private information, this is what economists call signalling. [*] In order for a signal to be effective, it needs to meet two conditions. First, it must be costly. And second, it must be costly in such a way that the low-quality restaurants wouldn't want to attempt the signal.

Now, let's consider the signalling value of award certificates. Is an award certificate costly? Yes, getting an award certificate is costly for a restaurant. The restaurant operators would have to work hard on quality of food and ingredients, and the quality of service, in order to win a certificate. [**] Is an award certificate costly in such a way that the low-quality restaurants wouldn't want to attempt the signal? A low-quality restaurant is low quality because of poorer quality food and service (and whatever other criteria are considered in the awarding of the certificate). If the low-quality restaurant operators were willing to pay the costs of higher quality food and ingredients and higher quality service, then they would do so (and they would be a high-quality restaurant, not a low-quality restaurant). So yes, the low-quality restaurant operators wouldn't attempt the signal, and so it does appear that award certificates are a good signal of quality.

However, not every high-quality restaurant can win an award certificate every year. So, what if the certificates on the wall are five or ten years old? Is that still a good signal of quality? I look at those ancient certificates (more than five years old), and I see a restaurant that is past its peak. It's on a downward slide into oblivion. It's not signalling high quality to me today, it's signalling that the restaurant used to be high quality, but not any longer.

There are two reasons why a restaurant would keep ancient award certificates on the wall. First, they are genuinely on the downward slide, but they want patrons to think that they are still high quality. But, if they were genuinely still high quality, they would still be winning award certificates. Given that they are not winning, then they are really signalling to patrons that they haven't maintained their previous quality.

Second, maybe the award certificates are given out in such a way that multiple winners are excluded. Call this the 'give everyone else a chance' effect. In that case, the award certificates are not such a great signal of quality, since they are not awarded to the highest quality restaurants, but to the highest quality restaurants that haven't been excluded for winning too many times. The quality of the signal is lessened, and patrons shouldn't pay as much attention to the award certificates.

So, a real high-quality restaurant, that hasn't won an award for several years, would probably be better off taking down their ancient award certificates, if they don't have any recent ones, then leaving those ancient certificates on the wall. Ancient restaurant award certificates are a negative signal of quality.

Changing tack now, I have a bunch of ancient award certificates myself - my teaching awards (six of them in total). I've been thinking about hanging them on my office wall. However, I haven't won an ward since 2020. Now that I've thought about restaurant signalling, I'm reconsidering whether I should hang those teaching award certificates on my office wall. Would they just signal that I'm on a downward slide? On the other hand, I continue to be nominated every year, and by multiple students every year. Maybe my lack of award winning is just the 'give everyone else a chance' effect at play?

[HT: Inspired by this Tyler Cowen post from December last year]

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[*] The patrons (the uninformed party) can also try to reveal the private information about restaurant quality. When the uninformed party (the party that doesn't know the private information) tries to credibly reveal the private information, this is what economists call screening. 

[**] If that wasn't the case, then the certificate provides no signalling value at all.

Tourist levies and tourist spending

The New Zealand Herald reported earlier this month:

An international tourism levy charged to visitors to New Zealand will increase to $100 – a jump of almost 200% – in a decision the Government believes will help boost economic growth and support conservation.

But it has some in the sector concerned the increase will be a barrier to visitors coming to New Zealand.

The International Visitor Conservation and Tourism Levy (IVL) is currently set at $35 and is charged to most tourists, people on working holidays, some students and some workers coming to New Zealand.

The IVL acts as a form of two-part pricing (which you can read about here). A firm uses two-part pricing when it splits the price into two parts: (1) an up-front fee for the right to purchase; and (2) a price per unit. If the consumer wants to buy any of the product, they must first pay the up-front fee. In the case of the IVL, it isn't a firm that's using two-part pricing, it is New Zealand as a whole. Tourists to New Zealand, if they want to buy any tourism experiences in New Zealand, must first pay the IVL.

The effect of the IVL on tourist spending is shown in the consumer choice model diagram below. In this case, the consumer is a tourist. They can spend their income (M) on either of two goods: NZ goods (as a tourist) with price Px, or overseas goods with price Py. The tourist's budget constraint with no IVL is the black line. The highest indifference curve that they can reach is I0, and they will buy the bundle of goods E0, which includes X0 NZ goods, and Y0 overseas goods. Now consider the impact of the IVL. The IVL takes income away from the tourist, but they don't receive any NZ goods in exchange for it (they just receive the right to buy NZ goods, as they can enter the country). That shifts the tourist's budget constraint inwards to the blue line (note that the end points on the budget constraint now have income (M-F), where F is the amount of the IVL). The tourist cannot buy the bundle of goods E0 anymore, as it is outside their budget constraint (it is outside the feasible set). The highest indifference curve that they can reach is now I1, and they will buy the bundle of goods E1, which includes X1 NZ goods, and Y1 overseas goods.

Now consider what this means for the government and for tourism operators in New Zealand. Overall, the tourist is spending more money in New Zealand now. We know this because they are buying fewer overseas goods (Y1 instead of Y0), and since they are still spending all of their income, they must be spending less on overseas goods (because the price of overseas goods is still Py), and more in New Zealand (made up of the IVL and what the tourist spends on NZ goods). The government might see that as a good thing.

On the other hand, the tourist is now buying fewer NZ goods (X1 instead of X0). That clearly isn't a good thing for New Zealand tourism operators, because tourists are spending less on NZ goods. It is little wonder that tourism operators are not happy about the IVL increasing. [*]

It gets worse for NZ tourism operators though, when we consider heterogeneous tourists. The diagram below shows two different consumers - a high-demand tourist (who spends a lot on NZ goods) shown in blue, and a low-demand tourist (who spends very little on NZ goods) shown in red. After the IVL is introduced, the high-demand tourist moves from buying bundle EH0 to bundle EH1. This means that they buy fewer NZ goods (XH1 instead of XH0), but spend more in NZ in total (just like the previous diagram, because they are buying less overseas goods - YH1 instead of YH0). However, the low-demand tourist's best affordable choice after the IVL is introduced is to stop buying any NZ goods at all, and not pay the IVL at all. They would consume the bundle EL1, spending all of their income on overseas goods (and buying no NZ goods at all instead of XL0).

Tourism operators might console themselves that while there will be fewer tourists, the remaining tourists are those that buy a lot of NZ goods. However, high-demand tourists could even end up spending less in NZ overall, as shown in the diagram below. In this diagram, I only show the high-demand tourists (for simplicity). Notice that in this case, once the IVL is introduced the high-demand consumers move from buying bundle EH0 to buying bundle EH1, and they end up buying less NZ goods (XH1 instead of XH0), but more overseas goods (YH1 instead of YH1). Since they are buying more overseas goods, they must be spending more on overseas goods (because the price of overseas goods is still Py), and therefore spending less in NZ overall (even when you add the IVL plus their spending on NZ goods).

Which of these scenarios will play out? Will consumers end up spending more overall (combining the IVL and spending on NZ goods)? Low-demand tourists will stop visiting, but how many will do so? Will high-demand tourists spend more overall, or less? These are all relevant questions that it would be worthwhile to answer. And the New Zealand tourism industry really needs some answers, because it will be really consequential for their revenue and profits.

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[*] Note that the diagram doesn't show the effect of increasing the IVL. However, comparing IVL with no-IVL is qualitatively the same as comparing smaller-IVL with larger-IVL.

This week in research #42

Here's what caught my eye in research over the past week:

• Yotov (with ungated earlier version here) presents a historical overview of the gravity model (used in trade and migration studies, and I love that the concluding section is titled "Gravity is endless fun")
• Bokhari et al. (open access) use UK data to show that minimum unit pricing of alcohol was remarkably effective and well‐targeted in reducing demand for cheap alcohol during the pandemic lockdowns, with minimal spillover effects, and consumers overall buying and spending less
• Reilly, Williams, and Das find that Office of Civil Rights (OCR) investigations of colleges and universities in the US are associated with lower recorded sexual assaults at private and public research schools and private baccalaureate schools, but not at public baccalaureate schools (so context matters)
• Heutel argues that theme park rides are Giffen goods, noting that when the price of a ride increases - that is, the wait time increases, then the probability of riding it increases (I'm not convinced, and I don't find the results that establish that rides are inferior goods convincing - if people have more time in the theme park (an increase in 'income' in Heutel's model), and holding wait times constant, are there rides that they would ride less as a result?)

Adrian Katz on public sector discounting

This week, my ECONS102 class has been covering the economics of education. One of the key aspects of the topic is the introduction of discounting. This is important in the private education decision (about how much education to invest in), because the benefits of education come in the future, while the costs (including opportunity costs) happen now. In order to make an effective decision, we need to discount the future benefits so that they can be compared with the present costs.

Discounting is also important in public sector decision-making, such as decisions on funding healthcare (and my ECONS102 class will turn its attention to health economics next week), transport and other infrastructure, environmental policy, and many other decisions where there are long-term benefits (and/or long-term costs).

So, I was interested to read this post on the Asymmetric Information substack yesterday by Adrian Katz (senior economist at NZIER), who gives a quick run-down on public sector discounting:

The public-sector discount rate plays a central role in determining which government interventions get the green light, and which stay on red...

The Treasury currently recommends a discount rate of 5.0% for most projects. The Treasury’s CBAx guidance also suggests an alternative rate of 2.0% but does not explain how this should be used.

Some government agencies use different discount rates. For example, NZTA uses a rate of 4.0%, and Pharmac uses 3.5%. Having different discount rates for different government organisations is at odds with the Treasury’s current approach and makes it harder to compare different types of government spending.

Katz then briefly outlines the debate over how the discount rate should be set. It is worth reading that debate if you want to understand more about how the discount rate is set currently. Katz then concludes that:

Arguments about the discount rate are often motivated by political views about the role of government in society or ethical views about what we owe to future generations. Policy advisors face difficulties in making these judgements on behalf of society without clear evidence of New Zealanders’ views on these complex issues.

The choice of discount rate can make a big difference to evaluating the present value of future costs and benefits. The Treasury recommendation of a 5 percent discount rate would discount an amount in 20 years' time by 62.3 percent (=1-[1/(1+0.05)^20]), and an amount in 50 years' time by 91.3 percent (=1-[1/(1+0.05)^50]). In contrast, using the Pharmac rate of 3.5 percent would discount those amounts by 49.7 percent (=1-[1/(1+0.035)^20]) and 82.1 percent (=1-[1/(1+0.035)^50]) respectively. So, $1000 in 20 years' time would have a present value of $377 using the Treasury rate, but $503 using the Pharmac rate. And $1000 in 50 years' time would have a present value of $87 using the Treasury rate, but $179 using the Pharmac rate.

With a lower discount rate (like Pharmac) more alternatives with long-term benefits and near-term costs would have benefits that are greater than costs (that is, a benefit-cost ratio greater than one). As a result, the government would have evidence in favour of investing in more infrastructure, more climate change mitigation, more education and more healthcare. Discount rates matter.