Advertising effectiveness and spillover: simulating strategic interaction using advertising

1. Advertising effectiveness and spillover: simulating strategic interaction using advertising 25th International Conference of the System Dynamics Society Boston, Massachusetts 29th July to 2nd August, 2007 Dr. Malcolm Brady Dublin City University Business School malcolm.brady@dcu.ie

2. Profit

3. Costs No fixed costs Cost is linear in quantity ie. no economies or diseconomies of scale

4. (inverse) Demand p a monopoly b = slope q a: reservation price b: own price effect (market response)

5. Product differentiation duopoly d: represents the cross price effect d/b: represents the extent of product differentiation Dixit, BJE, 1979

6. Cournot Nash equilibrium …(3) Game theory Strategic interdependency Cournot, 1838; Nash, 1951

7. Advertising • Selection of amount of advertising • Optimal amount: Dorfman Steiner • Impact of advertising on demand • Shifts demand function to the right • ie. changes intercept of inverse demand function • Tilts demand function • ie. changes slope of inverse demand function • Friedman • Cumulative • Interfirm (Spillover) effect • Cost of advertising • Reduces profit

8. Profit Π = pq – cq - A Dorfman-Steiner Advertising elasticity of demand Price elasticity of demand Δai = φiAi + ρφjAj i =1,2, j=3 - i Friedman …(4)

9. Assumptions • Production adjusts instantaneously to demand • No lags or delays; no spikes or step changes

10. The model • five stock variables • five flow variables • ten auxiliary variables • eight parameters

11. Initial and Parameter Values • a high volume low price product • Unit variable cost c set at $8. • The initial reservation price a is set at $25. • Own-price effect b is set at 0.0001 • Cross-price effect d at 0.00005.

12. + advertising elasticity advertising B1 + - R1 quantity + + reservation price

13. price elasticity - - + R2 R3 advertising + price - B2 quantity + + reservation price

14. Two firms: Arrays • Two sets of loops exist: one for the firm and one for its rival. • Additional interaction loops, generated by equation 3, exist: they are as above but with signs reversed. • Additional interaction loops, generated by equation 4, exist: they are as above but all variables except reservation price refer to the rival firm. • When advertising is predatory all signs are reversed.

16. Neither firm advertises φ1 = φ2 = 0 One firm advertises Both firms advertise φ1 = 0.000015; φ2 = 0 φ1 = φ2 = 0.000015 φ1 = 0.000013; φ2 = 0 φ1 = φ2 = 0.000013

17. One firm advertises with spillover Spillover is predatory φ1 = 0.000015; φ2 = 0; ρ = 0.1 φ1 = φ2 = 0.000013; ρ = -0.3 φ1 = 0.000013; φ2=0; ρ = -0.3 φ1 = 0.000015; φ2 = 0; ρ = 0.3

18. Some conclusions • Advertising can be an effective competitive weapon and can lead to competitive advantage • Bifurcation in industry behavior at threshold levels of advertising effectiveness • Some industries advertise and some do not • Spillover • Where advertising is a public good firms are less likely to advertise unless • all firms in the industry advertise • or firms advertise collectively • EU: Olive Oil Ads/ Ireland: Licenced Vintners Ads • Reduces the impact of advertising • Predatory may be more effective than complementary advertising