Chapter 10: Advertising

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Chapter 10 Advertising
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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

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Some figures

• Billions of dollars are spend on advertising, and
  more generally on marketing campaigns.
• Expenditures in OECD countries 1-3 of GNP.
• Compare with 6 expenditures on education
• Economists distinguish between
• Persuasive advertising
• changes consumer tastes
• Informative advertising
• provides information

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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

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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!

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

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Starting Points (cont.)

• This evidence though does not tell us the
  direction of causation
• does advertising increase profit?
• or does profits lead to advertising?
• However, advertising may enhance existing brands
  and reduce competition
• advertising then is wasteful
• especially if it intensifies product
  differentiation

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Early Economic Analysis

• 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.

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Wasteful Advertising Rivalry
Competition leads both firms to choose too high a
level of advertising
pZ (60 - SG)SZ - SZ2
pG (60 - SZ)SG - SG2
Gamma (SG)
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15
20
This is the Nash equilibrium
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(400, 400)
(350, 525)
(300, 600)
ZIP (SZ)
(525, 350)
(450, 450)
(375, 500)
15
(400, 400)
(600, 300)
(500, 375)
(400, 400)
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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
• But early work also revealed that advertising can
  be pro-competitive by increasing consumer
  information (Benhams, 1972, on eyeglasses)
• 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?

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Advertising as Signaling

• Nelson (1970, 1974) answers two questions just
  raised
• 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
• distinguished 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
• advertising provided information much the way
  suggested by Benhams eyeglass study
• experience goods, e.g., electrical goods,
  computers, wine, restaurant meals
• Here the issue is the quality of the good which
  can only be assessed after experience

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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?

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Game theory and advertising
2,2
Try
High quality firm
C
Stay out
Ad
-1,0
F
0,0
No
HQ
Low quality firm
N
LQ
F
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Advertising as signaling (cont.)

• Nelsons argument both theoretical and empirical
  obstacles
• At the theoretical level, it has been noted that
  low quality goods may be much cheaper to make.
• 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

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An oligopoly model of informative advertising.

• Linear city model
• Under perfect information demands are
• What if buyers are not informed about the
  products and firms advertise to let consumers
  know about them ?
• Let C(a ) k a2/2 be the cost of making sure
  that a consumer at random is reached by the
  advertising campaign with probability a

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Informative advertising (cont.)

• Then demands become
• And the profits of a firm
• First order conditions

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Informative advertising (cont.)

• Applying symmetry and solving yields
• Profits of the firms are
• and, interestingly, profits increase in k !

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Is there too much or too little informative
advertising?

• Advertising can be seen as creating a new good
  for the consumer that receives the ad.
• under the assumption that consumers ignore the
  good a priori
• Therefore, the private incentives to advertise
  are generally mis-aligned with respect to the
  social incentives
• Business-stealing effect
• leads to excessive advertising (firms sending ads
  to consumers who ultimately do not buy from them
  waste economic resources)
• Non-appropriability of total surplus
• leads to insufficient advertising since buyers
  appropriate some surplus, a social planner would
  advertise more than the firms.

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Advertising as a Complement

• Becker and Murphy (1993) advertising is a
  complement to consumption
• 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
  creating image that enables customers to use the
  product better

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