Chapter 10: Advertising

Industrial Organization: Contemporary Theory & Practice

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

Industrial Organization: Contemporary Theory & Practice

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

Industrial Organization: Contemporary Theory & Practice

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!
Industrial Organization: Contemporary Theory & Practice

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
Industrial Organization: Contemporary Theory & Practice

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
Industrial Organization: Contemporary Theory & Practice

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
Industrial Organization: Contemporary Theory & Practice

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 meetespecially 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 Lillys 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
Industrial Organization: Contemporary Theory & Practice

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
Industrial Organization: Contemporary Theory & Practice

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?
Industrial Organization: Contemporary Theory & Practice

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 everyones 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.
Industrial Organization: Contemporary Theory & Practice

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?
Industrial Organization: Contemporary Theory & Practice

Wasteful Advertising Rivalry

2 leads pCompetition = (60 S )S S Z G Z Z both firms to choose too high a level of advertising

pG = (60 - SZ)SG - SG2 Gamma (SG)

15 20

10 10 (400, 400)

This is the (350, 525) (300, 600)

(450, 450)

ZIP (SZ)

15

(525, 350)

Nash equilibrium

(375, 500)

20

(600, 300)

(500, 375)

(400, (400, 400) 400)

Industrial Organization: Contemporary Theory & Practice

Advertising: What is the Message?

As we have just seen, the early analysis argued that Advertising can affect consumer tastesBut this may not be bad Advertising can be wastefulBut the main losers appear to be the oligopolist firms who depress each others profits with excessive advertising But early work also revealed that advertising can be procompetitive by increasing consumer information Benhams (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?
Industrial Organization: Contemporary Theory & Practice

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 Benhams 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:
Industrial Organization: Contemporary Theory & Practice

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 purchasesdissatisfied consumer will not come back Nelson argued that this leads to an equilibrium in which only makers of high-quality goods will advertise. Why?
Industrial Organization: Contemporary Theory & Practice

Advertising as signaling (cont.)

Nelsons 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
Industrial Organization: Contemporary Theory & Practice

Advertising as signaling (cont.)

If Nelsons argument is correct, then the very fact that a firm advertises signals to consumers that the good is high quality. However, Nelsons 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, Nelsons argument suggests that firms may want to publicize just how expensive their advertising is. But we rarely if ever observe such behavior

Industrial Organization: Contemporary Theory & Practice

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
Industrial Organization: Contemporary Theory & Practice

Advertising and Crowd Appeal

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

N + 1 consumers of a particular good

Different tastes described by preferences on interval [0, q*] Consumer 1 gets utility 0 Consumer 2 gets utility q*/N Consumer n gets utility (n - 1)q*/N Final consumer gets utility Nq*/N = q*
Industrial Organization: Contemporary Theory & Practice

Advertising and Crowd Appeal (cont.)

Advertising affects utility for each consumer For each consumer advertising expenditure of S increases utility

by a multiple s(S): consumer n gets utility s(S) (n - 1)q*/N Assume that s(1) = 1 and that s(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(S) (n - 1)q*/N > P

This identifies the marginal consumer nm =

Industrial Organization: Contemporary Theory & Practice

NP

s(S)q*

+1

All consumers Advertising and Crowd Appeal (cont.)

above nm buy The minimum value of nm is 1 and the maximum value is N + 1

The number of consumers is N + 1 - nm

= N - NP/ s(S)q*

So demand at price P and advertising expenditure S is:

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

$ s(SH)q* s(SL)q*
DH

Demand with high advertising

Demand with low advertising

Suppose that advertising expenditure is SL This gives demand DL

Increase advertising expenditure to SH

DL

Demand increases to DH

Quantity

Industrial Organization: Contemporary Theory & Practice

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 goods existence
Industrial Organization: Contemporary Theory & Practice

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
Industrial Organization: Contemporary Theory & Practice

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) Different approaches to So demand at price P and advertising intensity S is advertising give different impacts on demand QD(P,S) = g(S)(a - bP)
$

Suppose that advertising expenditure is SL

a/b

Demand with high advertising

Demand with low advertising DH g(SL)a

This gives demand DL

Increase advertising expenditure to SH

DL

Demand increases to DH

g(SH)a Quantity

Industrial Organization: Contemporary Theory & Practice

Profit Maximizing Choice of Advertising

Take the advertising as information approach: Q(P, S)to = be g(S)(a - bP) This has

Suppose that marginal production costs are c and that each ad costs t

to issue
Then profit is p(P, S) = (P - c)Q(P,S) - tS

maximized with respect to P and S

For any demand curve we know that marginal revenue can be written

of demand MR = P(1 - 1/hP) where hP is the price Thiselasticity relates the pricecost margincost with the Condition 1 (on P): marginal revenue equals marginal price elasticity of P*(1 - 1/hP) = c so P* - c = P*/hP demand P* - c 1 so = hP P*
Industrial Organization: Contemporary Theory & Practice

Profit Maximizing Advertising (cont.)

Now consider advertising expenditures The profit maximizing choice of S satisfies: p(P, S)/ S = (P - c) Q/ S - t = 0 so Q (P - c) = t S Q S (P* - c) t = P* P*

but then recall that so Q S

P* - c 1 = P* hP 1 t = P* hP
Industrial Organization: Contemporary Theory & Practice

Profit Maximizing Advertising (cont.)

We have Q S 1 hP Q S

t P*

Multiply both sides by S*/Q* S* Q* 1 hP

tS* P*Q* S* Q*

Consider the expression

This is an elasticity: the elasticity of demand with respect Q to advertising expenditures S hS hP

So the left hand side becomes

Industrial Organization: Contemporary Theory & Practice

Profit Maximizing Advertising (cont.)

Now consider the expression tS* P*Q* The numerator is total advertising expenditure The denominator is sales revenue So we have the condition Advertising Expenditure = Sales Revenue hS hP

Industrial Organization: Contemporary Theory & Practice

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

Industrial Organization: Contemporary Theory & Practice

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

Industrial Organization: Contemporary Theory & Practice