Title: AEM 4550: Economics of Advertising Prof. Jura Liaukonyte
1LECTURE 4 5 PRODUCT DIFFERENTIATION AND
PERSUASIVE ADVERTISING
- AEM 4550Economics of AdvertisingProf. Jura
Liaukonyte
2Lecture Plan
- LI and Dorfman Steiner revisited
- Product differentiation and advertising
- Taxonomy of product attributes
- Search
- Experience
- Credence
- Taxonomy of advertising types
- Persuasive Advertising
- PBS Frontline Persuaders
3Lerner Index
- L (p - MC)/p 1/ED
- PUNCHLINE If elasticity increases, mark-up will
decline. If the product becomes less elastic,
mark-up will increase.
4Advertising and Monopoly Power
- Assume a firm faces a downward-sloping
demandinverse curve but one that shifts
depending on the amount of advertising A that
the firm does - PP(Q, A)
Recall, the Lerner Index, LI
L (p - MC)/p 1/EP
Where EP is the price elasticity of demand
5Advertising and Monopoly Power
- The elasticity of output demand with respect to
advertising ?A is defined as
We can derive the following relationship
Advertising/sales ratio
Dorfman-Steiner Condition For a
profit-maximizing monopolist, the
advertising-to-sales ratio is equal to the ratio
of the elasticity of demand with respect to
advertising relative to the elasticity of demand
with respect to price.
6Intuition Behind D-S
- Recall the greater the demand elasticity, the
lower the optimal price. - price-cost margin is smaller when elasticity is
higher. Since the price-cost margin is smaller
with elastic demand, the gain from advertising is
also smaller even if the increase in quantity
demanded is the same. - The marginal gain from advertising is greater the
greater the price-cost margin.
7Dorfman-Steiner
- The Dorfman-Steiner formula relates the
advertising-to-revenues ratio to price-cost
margin and elasticity. - The advertising-to-sales ratio is greater the
greater the advertising elasticity of demand and
lower the price elasticity of demand (or the
greater the price-cost margin).
8Example
- Suppose you have been hired to marker a new music
recording that is expected to have target sales
of 20 million for upcoming year - The marketing department has estimated that 1
increase in advertising will translate to 0.5
increase in sales - And that 1 increase in the price of the
recording would reduce the number sold by about
2 - How much money should you commit to advertising
the recording in the coming year?
9Advertising to Sales Ratios
- This ratio varies between industries
- Salt industry a-s-r 0 to .5
- Breakfast cereals industry a-s-r 8 to 13
- Advertising intensity depends on
- The type of product
- Advertising elasticity of demand
- Price elasticity of demand
10Highest Ad-to-Sales Ratios
11Lowest Ad-to-Sales Ratios
12Example
13Advertising to Sales Ratios
- Industry Average is 7.6 and has grown
- over the last few years
14Example
15Ad to Sales Ratios
16Ad to Sales Ratios
- High or low?
- Transportation/Travel industry 1.9
- Consumer Products, Books, PayTv, Communications,
all gt 5 - Downward Trend
17Stylized Facts About Advertising
- Volume of advertising expenditures is large. For
the US, advertising expenditures total to over
2 of GDP - Underneath this national total is a wide variety
in firm advertising behavior - Car makers (e.g., GM) and household product firms
(e.g., Proctor Gamble) spend the most on
advertising - Basic patterns that emerge are
- Correlation between advertising market power
- Consistency of advertising behavior within
industriesbig advertisers remain big over time
and across countries
18Ad Elasticity and Concentration
- Each firms advertising elasticity decreases as
concentration decreases. - The more fragmented the industry is, the lower
the benefit from advertising that is captured by
the firm that pays for it. - With more firms in the industry, a firms "split
of the pie" is smaller.
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20Product Differentiation
- Products are different if there is some objective
characteristic or property, real or perceived,
that provides a basis for buyers to choose one
over the other. - Product differentiation may lead to reduced own
-price elasticity. As the degree of
differentiation increases, the price elasticity
will decrease.
21Product Differentiation, cont.
- Ways in which products are differentiated.
- Product Brand
- Packaging
- Conditions of Sale
- Service Provided
- Location
- Product Differentiation as an Entry Strategy
- Product differentiation to create a niche market.
- Product differentiation to deter entry.
22Product Positions in Characteristics Space
What could advertising do to change these
positions? Are perceived and real characteristics
the same thing?
23Advertising and Product Differentiation
- Advertising product characteristics increases
product differentiation. - Consumers are more informed about objective
product differences. - Firms can create some sort of subjective product
difference. - Advertising in this case softens competition due
to heightened awareness of product
differentiation. - Soften competition the industry is less
competitive and firms have more market power. - Strengthen competition the industry is more
competitive and firms have less market power. - Firms are able to avoid Bertrand competition by
advertising.
24Advertising and Product Differentiation
- Advertising product characteristics increases
product differentiation. - Consumers are more informed about objective
product differences. - Firms can create some sort of subjective product
difference. - Advertising in this case softens competition due
to heightened awareness of product
differentiation. - Soften competition the industry is less
competitive and firms have more market power. - Strengthen competition the industry is more
competitive and firms have less market power. - Firms are able to avoid Bertrand competition by
advertising.
25Perceptual Maps
26Perceptual Map Credit Cards
27Perceptual Map Credit Cards
Uniformity
American Express
Selectivity
Accessibility
Chase
B of A
Citi
Variety
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29- http//www.google.com/trends?qnook2Ckindle2Ci
padctab0geoalldateytdsort0
30On the other hand
- Advertising can increase price competition when
firms advertise about their prices. - If prices were artificially high due to imperfect
price information, then firms have an incentive
to advertise about their prices to attract more
consumers. - Rival firms will soon follow suit and advertise
about their prices. This leads to higher
expenditures on advertising and lower prices. - Advertising in this case strengthens competition
due to heightened awareness of prices.
31Taxonomy of Products and Their Attributes
32Understanding Customer
- Search attributes are those that a customer can
determine prior to purchasing the goods and/or
services. These attributes include things like
color, price, freshness, style, fit, feel,
hardness, and smell. - Goods such as supermarket food, furniture,
clothing, automobiles, and houses are high in
search attributes.
33Understanding Customer
- Experience attributes are those that can be
discerned only after purchase or during
consumption or use. - Examples of these attributes are friendliness,
taste, wearability, fun, and customer
satisfaction.
34Understanding Customer
- Credence attributes are any aspects of a good or
service that the customer must believe in, but
cannot personally evaluate even after purchase
and consumption. - Examples would include the expertise of a surgeon
or mechanic, the knowledge of a tax advisor, or
the accuracy of tax preparation software.
35Taxonomy of Goods-Nelson (1974), Lieberman and
Flint-Goor (1996)
Search Goods Non-Durable Exp. Goods Durable Exp. Goods Experience Services Credence Services
Clothing Furniture Footwear Carpets Mattresses Health/Beauty Cigarettes Food Cleaners Newspapers Office Supplies Housing Autos Hardware Drugs Glass Software Signs Books Sporting Goods Hobbies Utilities Advertising Transportation Vacations Education Training Tours Banking Car Rentals Entertainment Direct Mail Real Estate Cargo Job Placement Information Nursing Homes Sports Clubs Hotels Waste Collection Landscaping Investments Trusts Portfolio Management Mutual Funds Insurance Health Care Weight Control Car Repairs
36Key Point
- Firm (Brand) Reputation is more important for
experience goods than search goods and most
important for credence goods. - Has implications on advertising effects on
demand.
37 Product Attributes
Most Goods
Most Services
Difficult
Easy
to evaluate
to evaluate
Computer repair Education Legal
services Complex surgery
Clothing Chair Motor vehicle Foods
Restaurant meals Lawn fertilizer Haircut Enter
tainment
High in search
High in experience
High in credence
attributes
attributes
attributes
38How the Internet affects
- Search goods
- Can facilitate consumers' ability to obtain
attribute information. - Experience goods
- Difficult to provide enough experience for
consumers to assess the benefits of the product ?
Offline trial Online purchase - Credence goods
- How to help consumers form a set of beliefs about
the quality of the product? ? Access to other
people's beliefs about the quality of the product
such as product testimonials
39Advertising Taxonomy
- Why do consumers respond to advertising?
- An economic theory of advertising can proceed
only after this question is confronted. - As economists have struggled with this question,
3-4 views have emerged, with each view in turn
being associated with distinct positive and
normative implications.
40Main Views of Advertising
- Persuasive
- Informative
- Complimentary
- Memory Jamming (Reminder)
41Life Cycle of Product
42Persuasive Advertising
43Persuasive Advetising
- The persuasive view holds that advertising alters
consumers' tastes and creates spurious product
differentiation - The demand for a firm's product becomes more
inelastic - Advertising results in higher prices.
- Such advertising by established firms may give
rise to a barrier to entry, which is naturally
more severe when there are economies of scale in
production and/or advertising differentiation and
brand loyalty.
44Persuasive Advertising and Product Types
- Recall, reputation is more important for
experience goods than search goods and most
important for credence goods. - Reputation and Persuasion are synonyms in this
case. - Among which type of products will we observe high
levels of persuasive advertising? - Search, Experience or Credence?
45The Pervasiveness of Persuasion
- The average person is exposed to 300-400
persuasive messages per day from the media alone
(Rosseli, Skelly, Mackie, 1995) - The average person is exposed to 1,000
commercials per week (Berger, 2004) - An average of 800 per person is spent on
advertising in the U.S. each year (Berger, 2004)
46Obvious Forms of Persuasion
- A 30 second spot for Super Bowl costs 3-4
million for a 30 second spot. - Product placements in movies and TV amounted to
2.5 billion in 2005 (PQ Media). - Morgan (2005) between 15-30 products are
inserted in every half hour of television
programming.
- Product Placement on American Idol
47Product Placement
- http//www.brandchannel.com/brandcameo_films.asp
- Featured Brands Apple, Bell, Cadillac, Chock
Full ONuts, Chrysler, Cisco, Ford, Ford Mustang,
Hill-Rom, HP, Lacoste, Listerine, Los Angeles
Dodgers, Mercedes, Motorola, Pepsi, Philips,
Pontiac, Pyrotect, Rolls Royce, San Francisco
Giants, Sharp, The North Face, The Riviera Hotel
and Casino, Timberland, Toyota, United States
Parachute Association
- Featured brands Apple, Belstaff, BMW, Citibank,
Datascope, Ford, Ford Mustang, Hamilton, Honda,
Hummer, JVC, Kleenex, Loews, Magnavox,
McDonald's, MetLife, Mobil, Nautilus, NBC,
Nissan, Panasonic, Ronzoni, Salvatore Ferragamo,
Sbarro, Spam, Staples, Tic Tac, Time, Verizon,
Viking, XM Satellite Radio
48Model of Persuasive Advertising
- Total of N consumers in the market.
- Each consumer will buy only one unit of the
primary good. - Each consumer has a different value, vi, for the
primary good. - Advertising increases each consumers value by
the same factor, ?, regardless of their initial
value. Thus each consumers value with
advertising is ? vi.
49Model of Advertising and Crowd Appeal
50Model of Persuasive Advertising
- Increase in consumers willingness to pay, ?, is
a function of the amount spend on advertising, s.
- As s increases, ?(s) increases, as does consumer
demand and profit. - Firms will select the level of advertising that
maximizes profit, i.e., the level of s where the
marginal revenue from s is equal to the marginal
cost of s.
51Model of Persuasive Advertising
- In this model, higher levels of advertising lead
to higher prices because the advertising
increases the consumers willingness to pay. - Also, advertising can increase consumer surplus
as well as firm profit, since advertising
increases a consumers value. - More about that later, when we talk about
complementary view.
52PBS Frontline PERSUADERS
- http//www.pbs.org/wgbh/pages/frontline/shows/pers
uaders/