LECTURE 4 & 5: PRODUCT DIFFERENTIATION AND PERSUASIVE ADVERTISING

1. LECTURE 4 & 5: PRODUCT DIFFERENTIATION AND PERSUASIVE ADVERTISING AEM 4550:Economics of AdvertisingProf. Jura Liaukonyte

2. Lecture 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

3. Lerner 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.

4. Advertising 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 • P=P(Q, A) Recall, the Lerner Index, LI L = (p - MC)/p = 1/|EP| Where |EP| is the price elasticity of demand

5. Advertising 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.

6. Intuition 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.

7. Dorfman-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).

8. Example • 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?

9. Advertising 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

10. Highest Ad-to-Sales Ratios

11. Lowest Ad-to-Sales Ratios

12. Example Credit Card Industry

13. Advertising to Sales Ratios • Industry Average is 7.6% and has grown • over the last few years

14. Example Airline Industry

15. Ad to Sales Ratios

16. Ad to Sales Ratios • High or low? • Transportation/Travel industry =1.9 • Consumer Products, Books, PayTv, Communications, all > 5 • Downward Trend

17. Stylized 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 industries—big advertisers remain big over time and across countries

18. Ad Elasticity and Concentration • Each firm’s 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 firm’s "split of the pie" is smaller.

19. Chapter 2: Basic Microeconomic Tools

20. Product 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.

21. Product 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.

22. Product Positions in Characteristics Space What could advertising do to change these positions? Are perceived and real characteristics the same thing?

23. Advertising 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.

24. Advertising 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.

25. Perceptual Maps

26. Perceptual Map: Credit Cards

27. Perceptual Map: Credit Cards Uniformity American Express Accessibility Chase Selectivity B of A Citi Variety

29. http://www.google.com/trends?q=nook%2C+kindle%2C+ipad&ctab=0&geo=all&date=ytd&sort=0http://www.google.com/trends?q=nook%2C+kindle%2C+ipad&ctab=0&geo=all&date=ytd&sort=0

30. On 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.

31. Taxonomy of Products and Their Attributes

32. Understanding 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.

33. Understanding 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.

34. Understanding 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.

35. Taxonomy of Goods-Nelson (1974), Lieberman and Flint-Goor (1996)

36. Key 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 Entertainment High in search High in experience High in credence attributes attributes attributes

38. How 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

39. Advertising 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.

40. Main Views of Advertising • Persuasive • Informative • Complimentary • Memory Jamming (Reminder)

41. Life Cycle of Product

42. Persuasive Advertising

43. Persuasive 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.

44. Persuasive 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?

45. The 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)

46. Obvious 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

47. Product Placement http://www.brandchannel.com/brandcameo_films.asp Featured Brands: Apple, Bell, Cadillac, Chock Full O’Nuts, 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

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

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

50. Model 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.