Advertising Basics

Provided by someone with a definite agenda, but not necessarily the producer of the product.

Provided free -- you do not pay directly for the advertising.

Not free to the firms, so there must be some benefit to them -- increased profit.

In general, industries with highest levels of advertising also consumer good industries with highest profits.

Advertising as Product Differentiation Advertising as a wasteful, rent-seeking

behavior. Once products are differentiated in the

eyes of the consumer, the firms gain market power. Classic monopolistically competitive

model. Price will rise above marginal cost. There will be deadweight loss.

Monopolistic Competition

Advertising as a barrier to entry

If an industry is characterized by a high level of advertising, potential entrants must invest heavily in advertising to “launch” new products. Fixed costs of entry increase, increasing

scale at which firm must compete in order to become profitable.

May decrease the number of firms in an industry, thus increasing price.

Advertising as part of a “prisoner’s dilemma”

Marlboro’s (M) Strategies

Don't Advertise AdvertiseCamel’s (C)Strategies

Don'tAdvertise

$ 4 million (C)$ 4 million (M)

$1.5 million (C)$5.5 million (M)

Advertise $5.5 million (C)$1.5 million (M)

$3 million (C)$3 million (M)

Model of Advertising as a “Capture the Consumer” Game Consumers know about a product

category in general, but are not well informed about the characteristics of individual products. Example: don’t know where all the

grocery stores in Williamsburg are located.

Firms advertise to inform consumers, but only some consumers “hear” the advertisements.

“Capture the Consumer” Game Con’t Assume two firms, X and Y. Probability that any customer hears an

advertisement from firm i is i.

Thus (x*(1-y)) consumers know about X,

(y*(1-x)) know about Y, xy are perfectly

informed, (1-x)(1-y) are uninformed.

“Capture the Consumer” Game Con’t

Firm only competes on price for perfectly informed consumers, so price is higher than it would be if all firms were perfectly informed.

As firms try to reach more consumers, they must spend more money on advertising (diminishing returns to advertising).

Higher price in part funds advertising.

Positive Views on Advertising

Advertising can be a “good” itself with a positive value to consumers.

Advertising can provide information and lower a consumer’s search costs. In states with restrictions on price

advertising (prescription drugs, alcohol) prices are generally higher.

Advertising can signal quality.

Advertising as a Complement to Monopoly Power Advertising can help increase the value

of a good. Advertising is a complement to primary

good; consumers value joint consumption of the primary good and the ad.

Firms advertise to increase the demand for the primary good.

This theory applies to a broad range of goods.

Model of Advertising and Crowd Appeal 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 consumer’s

value by the same factor, , regardless of their initial value. Thus each consumer’s value with advertising is * vi.

Model of Advertising and Crowd Appeal$

Quantity

MC

Demand without advertising

Profit

*

Demand with advertising

Model of Advertising and Crowd Appeal, con’t

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.

Model of Advertising and Crowd Appeal, con’t

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 consumer’s value.

Model of Advertising as Information Total of N identical consumers in the

market. Each consumer will buy q(P) if informed

about the product. Advertising informs consumers about

the existence and/or usefulness of the product.

Number of consumers informed depends on the amount spent on advertising.

Model of Advertising as Information$

Quantity

MC

Demand with low advertising

Profit

Demand with high advertising

Model of Advertising as Information, con’t As s increases, so does demand and profit. Firms select advertising to maximize profit,

i.e., s where MR from s is equal to the MC of s.

In this model, higher levels of advertising do not lead to higher prices.

Advertising does increase consumer surplus as well as firm profit, since advertising increases the number of consumers that get a surplus.

Comparison of these two models

Complementary Goods Model: Higher advertising leads to higher

demand for each consumer, which leads to higher prices.

Brand Recognition Model: Higher levels of advertising leads to

more consumers but not a higher demand for each consumer, so prices are not affected by advertising levels.

More About the Optimal Level of Advertising Use the Advertising as Information model. Assume an informed consumer has a

demand of q = a-bP. The number of informed consumers

depends on the level of advertising, s. Total demand Q = n(s)(a-bP). Assume that the firm has a constant

marginal cost of production of c and a constant marginal cost of advertising, .

More About the Optimal Level of Advertising, con’t If total demand Q = n(s)(a-bP), then the

inverse demand is P = a/b - Q/[b*n(s)] which we can rewrite as P = A - BQ/n(s).

Profits are =(A-BQ/n(s)-c)Q - s. First find Q* given s by taking the

derivative of profit w.r.t. Q and set = 0. A-2BQ/n(s) - c = 0 Q* = (A-c)*n(s)/2B. So P*=A-B[(A-c)*n(s)/2B]/n(s) = (A+c)/2.

More About the Optimal Level of Advertising, con’t Assume the firm increases s by one unit.

What happens to profit? Quantity sold will increase since

Q* = (A-c)*n(s)/2B. Call this amount Qs. P* is independent of s, so for the

additional units sold, firm gets (P* - c). So MR from one more unit of s is Qs(P*-c). The firm will advertise until = Qs(P*-c).

More About the Optimal Level of Advertising, con’t

Remember from the lecture on price discrimination that the price-cost margin for a monopolist is a function of demand elasticity.

(P*-c)/P* = 1/ (Lerner index) Use this with the condition for the

optimal amount of s: = Qs(P*-c). Rearrange to get: = Qs(P*/)

More About the Optimal Level of Advertising, con’t

So now we have =Qs(P*/) /P* = Qs/. Multiply both sides by s*/Q* to get:

s*/P*Q* = s*Qs/Q*. The l.h.s. is just advertising expenditures/

sales revenue (adv. to sales ratio). The r.h.s. can be broken down into two

parts: s*Qs/Q* and . The first is the elasticity of demand w.r.t.

adv. and the second is price elasticity.

More About the Optimal Level of Advertising, con’t So the optimal advertising to sales ratio

should be the same as the ratio of the elasticity of demand w.r.t to advertising to the elasticity of demand w.r.t. price.

This is known as the Dorfman-Steiner condition.

The more price inelastic demand is, the more should be spent on advertising.

The more advertising elastic demand is, the more should be spent on advertising.

More About the Optimal Level of Advertising, con’t

Note: critics often argue that advertising makes consumers more brand loyal, i.e. makes demand inelastic.

This derivation shows that the causation could be the other way around: Because demand is price inelastic, more advertising is optimal.

Elasticity of Demand with respect to Advertising “Shopping” goods: Relatively expensive

and infrequently purchased, so you shop around for them. Cars, computers, furniture. Advertising relatively unimportant, you

gather a lot of data on your own. “Convenience” goods: Relatively

inexpensive and frequently purchased. Shampoo, soda, beer. Advertising relatively effective.

Elasticity of Demand w.r.t. Advertising, con’t Add in Nelson’s categorization of

“Search” vs. “Experience” goods. Search: Quality can be identified before

purchase. Consumers search for the best total package of price and quantity.

Experience: Quality can only be determined after consumption. Consumers try different goods to determine whether or not to continue to use.

Elasticity of Demand w.r.t. Advertising, con’t

Search Experience

Shopping Lowestadvertisingelasticity

Convenience Highestadvertisingelasticity

Dorfman-Steiner in Action

Search Experience

Shopping Clothes 2.3Furniture 2.6J ewelry 2.5

Hotels 3.5Appliances 4.3Footwear 4.5

Convenience Greeting Cards3.7Retail FoodStores 1.4

Soap/ Detergent7.9Beer 8.4Books 4.0

Advertising and Signaling For experience goods, advertising can

also be used to signal quality. If a company engages in an expensive

ad campaign, you might infer that the good is high quality because only high quality firms could afford the campaign. Price is can also be used as a signal of

high quality.

Free Rider Problem in Advertising Advertising can have positive externalities

for other firms in an industry. With positive externalities, there will be

too little advertising due to free-riders. Thus we might suspect that in industries

with large numbers of firms (and thus large positive externalities) advertising levels would be relatively low. Supported by about 1/2 of studies.

Free Rider Problem con’t

One solution is group or cooperative advertising. Got Milk? Campaign. Plastics council. McDonald’s.