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The Role of Advertising in Product Differentiation and Market Strategy

Advertising is pivotal in creating subjective image differences, thus influencing product differentiation and market profitability. It serves as a direct channel for firms to inform consumers about their offerings, fostering increased demand and brand loyalty. While advertising can provide truthful information (informational advertising), it often leans towards persuasion aimed at shaping consumer preferences. This duality has implications for market power, pricing strategies, and social welfare, raising debates on whether it enhances or diminishes consumer well-being.

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The Role of Advertising in Product Differentiation and Market Strategy

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  1. ADVERTISING

  2. Advertisingaimstocreatesubjectiveimagedifferencesandhenceproductdifferentiation.Advertisingaimstocreatesubjectiveimagedifferencesandhenceproductdifferentiation. • Productdifferentiation is a tooltoincreaseprofitabilitybydecreasingtheelasticity of demand.

  3. Advertisingplays a key role in thedevelopment of the market strategy • Advertisingallowsfirmstoprovideinformationdirectlytoconsumers. • Ithelpsfirmstocreateorincreasedemandfortheirproducts. • Itallowsfirmstobuild a “brandimage”. • Itallowsfirmstodifferentiatetheirproducts.

  4. Types of Advertising • Wedistinguishbetweeninformalandpersuasiveadveritising. • Informational (orinformative) adveritisng is designedtoprovidetruthfulinformationaboutprice,locationorquality. (Does it?) • Empricialevidencesuggestthatadvertisingaboutprice (priceadvertising) results in lowerprices.

  5. Do youthinkthatadvertisingworks? Does it changeconsumerbehaviour? • As an example: AppleAdvertisingmayhelpmanufacturerstakeadvantage of economies of scale in productionanddistribution.

  6. Advertising is arguedtoimprovequality. Since manufacturersbuild a brandimageviaadvertisingtheytrytoliveuptothisimageandincreasethequality of production. • Advertisingmay be seen as a commitment. • Inreal life wealwaysfaceimperfectinformation. Informativeadvertisingincreases market demand as moreconsumersbecomeaware of theproduct. • Informativeadvertisingallowsfirmstoincreasedemand but at thesame time demandbecomesmoreelastic. (Why?)

  7. PersuasiveAdvertising • Intherealworldadvertising is morepersuasiveratherthaninformational. • Themainfocus of advertising is tobuildbrandloyalty. • Persuasiveadvertising is designedtoinfluenceconsumertastesover a particularproduct. • Persuasiveadvertisingcreates/increases market powerbecause it is designedtopersuadeconsumersthatthere is no/littlesubstituestotheirproducts. • Moreover, brandloyalty is an importanttoolfor an incumbentfirmto set-upentrybarriers.

  8. Informativeadvertisingdecreases market power/prices/profits. • Persuasiveadvertisingincreases market power/prices/profits. • So in a socialwelfaremannerpersuasiveadvertisingdecreasessocialwelfarewhereasinformativeadvertisingincreases it. (Really?)

  9. Cost of advertising (2009 US data-millions of dollars)

  10. AdvertisingandQuality • Phillip Nelson (1970,1974) developed a model on advertising. • Considertwoproducers of toothpaste. BothtoothpastescontainfluorideandhavetheAnericanDentalAssociationseal of approval. But thehigh-qualitytoothpastetasteswonderfulandthelowqualitytoothpastetasteshorrible. Thecosts of productionareassumedto be equal. • Who has a higherincentivetoadvertise?

  11. Largeadvertisingexpendituresbyhigh-qualitytoothpastemanufacturersignalconsumersthat it produces a highqualityproduct. Becauseonlyhigh-qualityproducersadvertiseextensively. (Do youagree?)

  12. WelfareEffects of Advertising • Doesadvertisingincreaseordecreasewelfare? • Dixit-Norman model. • Theyanalysedthewelfareeffects of advertising in monopoly, oligopolyandmonopolisticcompetition. Theirconclusionswerethesameforallmarkets. Wewillonlyconsiderthemonopoly model.

  13. From a socialwelfareperspective, allmonopolistsspendtoomuch on advertising. DixitandNormanshowedthatthisresultalsoholdsforoligopolyandmonopolisticcompetition. • Inthis model advertisingassumedto be purelypersuasive, therefore had no socialvalue. • Somecriticisethe model arguingthatinformativeadvertisingwouldhavepositiveimpact on socialwelfare. (Do youagree?)

  14. Anotherargument is thatadvertisingmaypositivelyinfluenceconsumer’sutilitybymakingthemaware of theproduct. (Do youagree?)

  15. Dorfman-Steiner Model • This model is alsoconstructedformonopoly. • Inthe model, onlyquantitiy is a function of advertising. Price is independent of advertising.

  16. D-S conditionstatesthattheproportion of revenue a firmwillspend on advertising is determinedbytheratio of advertisingelasticitytopriceelasticity. • A monopolistwillkeepspending on advertisinguntilthepoint it setsadvertisingtosalesratioequaltotheratio of theadvertising-to-priceelasticity. • Since this is a monopoly model, market power is highandpriceelasticty is lowsoadvertisingexpenditureswill be high.

  17. Inthe D-S model profitability is linkedtoadvertisingexpentiditures. • Thequestion is: Does a monopolistreallyneedsadvertising?

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