industrial organization: contemporary theory & practice chapter 10: advertising

Industrial Organization: Contemporary Theory & Practice

Chapter 10: Advertising


Introduction• The emergence of advertising is closely connected with the

emergence of mass media

• The result has been a tremendous revolution in the shopping experience

• Because of widespread advertising, modern consumers enter a store with a wealth of information about alternative products, styles, qualities, and prices

• This has changed the ways that firms market products

• In turn, the development of sophisticated advertising has altered

– structure of markets

– nature of firms


Impact of Advertising• Without advertising

– lack of information about products– shopping is generally local and based upon visual

comparison– firms can operate on a small scale as each competes for

a small local market• With advertising

– comparison shopping is considerably eased as consumers have better information about range of good on offer

– firms have an incentive to widen the range of goods they offer and to operate on a larger scale


Some Important Questions

• If advertising affects consumer buying behavior, how?– Does advertising alter consumer tastes?

• If so, how?• And is this bad or good?

– Or does advertising just provide consumers with more information

• In either case, does advertising promote efficiency or is it socially wasteful?

• Does advertising create new markets? Or does it merely exploit existing markets?

• Does advertising increase demand in general? Or does it increase demand for particular branded goods?

• None of these questions admit of easy answers!


Some Conceptual Issues• Distinguish national and local advertising

• Local

– low quality and cost

– primarily informative: availability, price, associated services

• National

– higher quality and cost

– much less informative

• little mention of price

– intended to create an image associated with a brand or firm


Starting Points• Advertising is a free service to consumers• But it is costly to produce• Must, therefore, generate a benefit for the firms involved• There is evidence that such benefits exist

– high advertising expenditures by industry associated with high levels of profitability

• High: cereals, perfumes, soap, pharmaceuticals• Low: hats, carpets, jewelry

• This advertising/profitability relationship has been relatively stable over time

• Moreover, it also tends to be the same industries over time that are characterized by both high advertising intensity and high profits


Starting Points (cont.)• This evidence though does not tell us the direction of causation

– does advertising increase profit?– or does profits lead to advertising?

• Besides causation, other issues arise, too– Advertising may permit new firms/products with lower costs

to compete with established goods by increasing consumer information

• Advertising may still raise profits • But in this scenario, advertising raises competition and so

is beneficial– However, advertising may enhance existing brands and

reduce competition• advertising then is wasteful• especially if it intensifies product differentiation


Preliminary: Truth in Advertising• Much popular discussion is concerned with the possibility of

fraudulent advertising, e.g. the “snake oil” sellers of the Old West • For advertising to be illegal it must contain claims that are

– demonstrably false– affect a significant number of consumers

• These criteria are often difficult to meet—especially for consumers. But rivals to illegally promoted goods may help– AstraZeneca makes the drug Nolvadex (generically Tamoxifen) – As of 1999, was the only drug approved for use to prevent breast

cancer in women at high risk for the disease– Eli Lilly’s drug, Evista (generically known as Raloxifene) has been

approved for treating breast cancer but not preventing it– Lilly advertised Evista to doctors as a preventitive and doctors

began to prescribe it.• AstraZeneca sued and won a court order that Lilly stop its promotion


Truth in advertising (cont.)• This case outlines the general approach of FTC in cases where

fraudulent advertising is found to have taken place– issue a “cease and desist” order– on rare occasions insist on a counter-ad being issued

• Of course, there are a number of other instances of dishonest or fraudulent advertising. A review of these cases implies that fraudulent advertising most likely– when purchase is necessary to test the claims, e.g., “eating

this product will make one lose weight”– when claiming compensation is far from easy– Consumer is not in a position to evaluate the claim– Consumer cannot obtain recourse if claim is found to be

false because the firm is a “fly-by-night” type


Early Economic Analysis• As note at the outset, advertising expenditure is considerable and may

account for over 2% of US GDP • Besides the possibility of dishonesty, early economic analysis focused

on two other effects of advertising– change in consumer preferences– creation of monopoly power

• Some evidence that advertising may raise market power comes from comparing national brands with generics– heavily advertised national brands always sell for a premium even

though chemically or structurally identical– the obvious inference is that advertising somehow creates a real or

imagined perception that the national brand is superior• But is this inefficient?• Is it even inaccurate?


Early Economic Analysis (cont.)

• However, the idea that advertising is harmful if it changes tastes needs to be carefully considered

– Suppose that the demand curve without advertising is P = 100 – Q, and marginal cost is c = 20. It is easy to show that the monopolist price is $60 at which the monopolist sells 40 units. Consumer surplus is $800.

– Suppose advertising raises everyone’s willingness to pay by $50 so that the demand curve with advertising is: P = 150 - Q

• The new profit maximizing price and output are: P = $85 and Q = 65.

• Consumer surplus is now $4227. Advertising has affected consumer tastes but this does not mean consumers are worse off. Consumer surplus has increased.


Early Economic Analysis (cont.)• The foregoing analysis is simple and the results can be altered.

Still, it makes the point that caution is needed in evaluating the economic effects of advertising

• One way to reverse the above finding is to introduce some competition– suppose all manufacturers reason that advertising will raise

profit and therefore all increase advertising– we might then get excessive (wasteful) advertising

• ZIP Airlines and Gamma Airlines compete through advertising expenditures SZ and SG

– profit for ZIP is (60 - SG)SZ - SZ2

– profit for Gamma is (60 - SZ)SG - SG2

– SZ and SG can take the values 10, 15 or 20– how much will each firm spend?


Wasteful Advertising Rivalry

Gamma (SG)

ZIP

(S

Z)

10 15 20

10

15

20

(400, 400)

= (60 - SG)SZ - SZ2 G = (60 - SZ)SG - SG

2

(350, 525) (300, 600)

(525, 350) (450, 450) (375, 500)

(600, 300) (500, 375) (400, 400)(400, 400)

This is theNash

equilibrium

This is theNash

equilibrium

Competition leadsboth firms to choose too

high a level ofadvertising


Advertising: What is the Message?• As we have just seen, the early analysis argued that

– Advertising can affect consumer tastes—But this may not be bad

– Advertising can be wasteful—But the main losers appear to be the oligopolist firms who depress each other’s profits with excessive advertising

• But early work also revealed that advertising can be pro-competitive by increasing consumer information

• Benham’s (1972) classic study showed eyeglasses were cheaper in states where advertising of prices was legal

• At the same time, many note that a lot of advertising, especially national brand advertising, does not even mention price or even the function of the product.

• Two related questions follow:– What is the role of such contentless advertising?– Can it be procompetitive?


Advertising as Signaling• Nelson (1970, 1974) was among the first to offer a formal answer to

the two questions just raised. He argued that:– Advertising would be informative even when it did not mention

price or function or other key features; and– This informative role would be positive for consumers

• Nelson distinguished between two types of goods– search goods, e.g., foodstuffs, sweaters

• Here the primary issue is where the goods are available, and what price they sell at

• For search goods, advertising provided information much the way suggested by Benham’s eyeglass study and so played a positive role

– experience goods, e.g., electrical goods, computers, wine, restaurant meals

• Here the issue is the quality of the good and that can be assessed only after purchase and experience:


Advertising as signaling (cont.)

• For experience goods advertising could be a signal of high quality even when it otherwise seems without content

– producer is better informed of true quality than buyer

– makers of high quality goods want to inform consumers

• they want repeat purchases

• if the producer of a high quality good can get the consumer to try it just once, he knows that the consumer will continue to buy

• Producers of a low quality good will not earn repeat purchases—dissatisfied consumer will not come back

• Nelson argued that this leads to an equilibrium in which only makers of high-quality goods will advertise. Why?


Advertising as signaling (cont.)• Nelson’s argument is based on the following logic

– Advertising in the current period incurs an immediate cost– The return to this investment comes mainly from the extra future

sales it generates as consumers come back again and again– For experience goods, whether consumers come make repeat

purchases depends on how the good worked the first time– advertising could “fool” consumers into trying a product that the

manufacturer knows is low quality but the manufacturer also knows that these consumers will not be back

• So a low quality good cannot earn the extra margin from repeat purchases necessary to make advertising worthwhile

– Consumers will be back to buy a high quality good• So a high quality good can earn the extra margin from repeat

purchases necessary to make advertising worthwhile• So only high-quality goods exhibit high advertising levels


Advertising as signaling (cont.)• If Nelson’s argument is correct, then the very fact that a firm

advertises signals to consumers that the good is high quality. However, Nelson’s argument has run into both theoretical and empirical obstacles

– At the theoretical level, it has been noted that low quality goods may be much cheaper to make. So, a firm that advertises a low quality good may find it worthwhile because even the returns from tricking consumers into trying it once may be substantial

– At the empirical level, there seems to be little correlation between advertising and independent measures of quality

– In fact, Nelson’s argument suggests that firms may want to publicize just how expensive their advertising is. But we rarely if ever observe such behavior


Advertising as a Complement• Becker and Murphy (1993) have suggested that advertising is best

viewed as a complement to consumption, i.e., advertising raises the value of the good consumed. This can happen in two ways– Advertising can act like a network externality to create crowd

appeal• Consumers like goods that other people know about• The more a brand is advertised and known the more

consumers like it• The more they like it, the more they buy it and this may

raise its value further– Advertising can make a good more valuable by providing key

information that enables customers to use the product better• For example, letting consumers know that membership in a

resort not only provides access to golf but also to tennis courts may make tourists willing to pay more to stay there


Advertising and Crowd Appeal

N + 1 consumers of a particular good Different tastes described by preferences on interval [] Consumer 1 gets utility 0 Consumer 2 gets utility /N …

Consumer n gets utility (n - 1)*/N Final consumer gets utility N*/N = *

• Both the crowd appeal and the information views can explain why consumer goods are more heavily advertised than producer goods and why firms keep advertising the same good long after its introduction

A Simple Model of the Crowd Appeal View of Advertising


Advertising and Crowd Appeal (cont.) Advertising affects utility for each consumer

For each consumer advertising expenditure of S increases utility by a multiple (S): consumer n gets utility (S) (n - 1)*/N

Assume that (1) = 1 and that (S) is increasing in S

Each consumer buys exactly one unit of the good at price P provided that there is consumer surplus from doing so So for consumer n to buy the good it must be the case that: (S) (n - 1)*/N > P

This identifies the marginal consumer nm =NP

(S)*+ 1


Advertising and Crowd Appeal (cont.) The minimum value of nm is 1 and the maximum value is N + 1

The number of consumers is N + 1 - nm

All consumersabove nm buy

All consumersabove nm buy

= N - NP/ (S)*

So demand at price P and advertising expenditure S is:

QD(P, S) = N(1 - P/ (S)*)

$

Quantity

Suppose that advertising expenditure is SL

N

(SL)* Demand with

low advertising

Demand with

low advertising

This gives demand DL

DL

Increase advertising expenditure to SH

Demand increases to DH

DH

Demand with

high advertising

Demand with

high advertising(SH)*


Advertising as Complementary Information• The crowd appeal approach assumes that consumers enjoy

advertising

• So they will seek out advertising

• If “messages” are sent they will be received

• But what if this is not the case?

• Then there is a “hit or miss” aspect to advertising

• This suggests an alternative approach

– advertising informs but is not certain to be received

– consumers buy a good only if they see an advertisement for it

– otherwise they are uninformed of the good’s existence


Advertising as Information (cont.)• To buy consumers must receive an advertisement• But consumers do not buy more if they see more

advertisements Let individual demand be q(P) = a - bP and let there be N consumers

Suppose that if one ad is issued the probability of each consumer receiving it is 1/N

Then if 2 ads are issued the probability of neither ad being seen by anyone is (1 - 1/N)2

And if S ads are issued the probability of no consumer seeing any of them is (1 - 1/N)S. This can be approximated by e-S/N


Advertising as Information (cont.) So if S ads are issued the number of consumers who see at least one and so consider buying is (1 - e-S/N)N = g(S)

So demand at price P and advertising intensity S is

QD(P,S) = g(S)(a - bP)

$

Quantity

Suppose that advertising expenditure is SL

This gives demand DL

Increase advertising expenditure to SH

Demand increases to DH

a/b

g(SL)a

DL

Demand withlow advertising

Demand withlow advertising

g(SH)a

DH

Demand withhigh advertising

Demand withhigh advertising

Different approaches toadvertising give different

impacts on demand


Profit Maximizing Choice of Advertising Take the advertising as information approach: Q(P, S) = g(S)(a - bP)

Suppose that marginal production costs are c and that each ad costs to issue Then profit is (P, S) = (P - c)Q(P,S) - S For any demand curve we know that marginal revenue can be written

This has to bemaximized with

respect to P and S

This has to bemaximized with

respect to P and S

MR = P(1 - 1/P) where P is the price elasticity of demand

Condition 1 (on P): marginal revenue equals marginal cost

P*(1 - 1/P) = c so P* - c = P*/P

so

This relates the price-cost margin with the

price elasticity ofdemand

This relates the price-cost margin with the

price elasticity ofdemand

P* - c

P*=

1

P


Profit Maximizing Advertising (cont.) Now consider advertising expenditures

The profit maximizing choice of S satisfies:

(P, S)/ S = (P - c) Q/ S - = 0

soQ

S(P - c) =

but thenQ

S

(P* - c)

P*=

P*

recall thatP* - c

P*=

1

P

soQ

S

1

P

=

P*


Profit Maximizing Advertising (cont.) We have

Q

S

1

P

=

P*

Multiply both sides by S*/Q*

S*

Q*

Q

S

1

P

=S*

P*Q*

Consider the expression S*

Q*

QS

This is an elasticity: theelasticity of demand with respect

to advertising expenditures

This is an elasticity: theelasticity of demand with respect

to advertising expenditures

So the left hand side becomesS

P


Profit Maximizing Advertising (cont.) Now consider the expression

S*

P*Q*

The numerator is total advertising expenditure

The denominator is sales revenue

So we have the condition

Advertising Expenditure

Sales Revenue=

S

P


Advertising Spending• This is the Dorfman-Steiner result

– consistent with a negative relationship between the elasticity of demand and advertising

– implies that low advertising induces high advertising rather than the other way round

– increase in advertising only affects share of revenue spent on advertising if it affects demand elasticity: advertising-to-sales ratio is constant if elasticities are constant

– more is spent on advertising if consumers react more to advertising• response is likely to be greater for “convenience goods”

– consumers value easily available information• than “shopping goods”

– consumers likely to shop around

– more spent on advertising experience than search goods


Advertising and Competition• Can we extend the Dorfman-Steiner result to markets in

which there is competition?– suppose there are “many” very similar firms

• then there is likely to be a free-rider problem

– each firm tempted to free-ride on others’ marketing efforts

• so too little advertising

• leads to the need for collaborative marketing efforts: “Drink Milk”

– suppose that there are few firms selling differentiated products• then expect stronger incentives to advertise

• may find a prisoners’ dilemma effect

• so there is a connection between advertising and industry concentration

• but this is not a causal relationship

industrial organization: contemporary theory & practice chapter 10: advertising

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