Advertising Basics

1. 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.

2. 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.

3. Monopolistic Competition

4. 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.

5. Advertising as part of a “prisoner’s dilemma”

6. 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.

7. “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, xy are perfectly informed, (1-x)(1-y) are uninformed.

8. “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.

9. 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.

10. 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.

11. 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.

12. $ * Demand with advertising  Demand without advertising Profit MC Quantity Model of Advertising and Crowd Appeal

13. 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.

14. 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.

15. 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.

16. $ Demand with high advertising Profit Demand with low advertising MC Quantity Model of Advertising as Information

17. 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.

18. 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.

19. 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, .

20. 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.

21. 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).

22. 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*/)

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

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

29. Dorfman-Steiner in Action

30. 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.

31. 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.

32. Free Rider Problem con’t • One solution is group or cooperative advertising. • Got Milk? Campaign. • Plastics council. • McDonald’s.