Lecture 18 Advertising, Market Power and Information

1. ECON 4100: Industrial Organization Lecture 18Advertising, Market Power and Information

2. Introduction • advertising closely connected with the emergence of mass media • => revolution in the shopping experience • This has changed the ways that firms market products • In turn, the development of sophisticated advertising has altered • structure of markets • nature of firms

3. Impact of Advertising • Without advertising • lack of information about products • shopping is generally local and based upon visual comparison • firms can operate on a small scale as each competes for a small local market • With advertising • comparison shopping is considerably eased as consumers have better information about range of good on offer • firms have an incentive to widen the range of goods they offer and to operate on a larger scale

4. Some Important Questions • Does advertising alter consumer tastes? • Or does advertising just provide consumers with more information • In either case, does advertising promote efficiency or is it socially wasteful? • Does advertising create new markets? Or does it merely exploit existing markets? • Does advertising increase demand in general? Or does it increase demand for particular branded goods? • None of these questions admit of easy answers!

5. Some Conceptual Issues • Distinguish national and local advertising • Local: • low quality and cost • primarily informative: availability, price, associated services (see the flyers we get every week!) • National • higher quality and cost • much less informative (little mention of price) • intended to create an image associated with a brand or firm

6. Starting Points • Advertising is a free service to consumers but it is costly to produce => must generate a benefit for the firms involved • There is evidence that such benefits exist • high advertising expenditures by industry associated with high levels of profitability • This evidence though does not tell us the direction of causation • does advertising increase profit? • or does profits lead to advertising?

7. Early Economic Analysis • Early analyses focused on two other effects of advertising • change in consumer preferences • creation of monopoly power • Some evidence that advertising may raise market power comes from comparing national brands with generics • advertised national brands sell at a premium even if chemically or structurally identical • advertising => real or imagined perception that the national brand is superior • But …is this inefficient?

8. Early Economic Analysis (cont.) • However, the idea that advertising is harmful if it changes tastes needs to be carefully considered • If demand curve without advertising is P = 100 – Q, and marginal cost is c = 20 • => monopolist price is $60 at which the monopolist sells 40 units. CS= $800. • Suppose advertising raises everyone’s WTP by $50 so demand curve with advertising is: P = 150 - Q => P* = $85 and Q* = 65 • CS is now $4227. Advertising has affected consumer tastes but this does not mean consumers are worse off…

9. Early Economic Analysis (cont.) • The foregoing analysis is simple and the results can be altered. Still, it makes the point that caution is needed in evaluating the economic effects of advertising • One way to reverse the above finding is to introduce some competition • suppose all manufacturers reason that advertising will raise profit and therefore all increase advertising • we might then get excessive (wasteful) advertising • ZIP Airlines and Gamma Airlines compete through advertising expenditures SZ and SG • profit for ZIP is (60 - SG)SZ - SZ2 • profit for Gamma is (60 - SZ)SG - SG2 • SZ and SG can take the values 10, 15 or 20 • how much will each firm spend?

10. Wasteful Advertising Rivalry Competition leads both firms to choose too high a level of advertising pZ = (60 - SG)SZ - SZ2 pG = (60 - SZ)SG - SG2 Gamma (SG) 10 15 20 This is the Nash equilibrium 10 (400, 400) (350, 525) (300, 600) ZIP (SZ) (525, 350) (450, 450) (375, 500) 15 (400, 400) (600, 300) (500, 375) (400, 400) 20

11. Advertising: What is the Message? • Early analysis argued that • Advertising can affect consumer tastes—But this may not be bad • Advertising can be wasteful—But the main losers appear to be the oligopolist firms who depress each other’s profits with excessive advertising

12. Advertising: What is the Message? • But early work also revealed that advertising can be pro-competitive by increasing consumer information • At the same time, many note that a lot of advertising, especially national brand advertising, does not even mention price or even the function of the product. • Two related questions follow: • What is the role of such contentless advertising? • Can it be procompetitive?

13. Advertising as Signaling • Nelson (1970, 1974): • Advertising would be informative even when it did not mention price or function or other key features; and • This informative role would be positive for consumers • Nelson distinguished between two types of goods • search goods, e.g., foodstuffs, sweaters • Here the primary issue is where the goods are available, and what price they sell at • For search goods, advertising provided information • experience goods, e.g., electrical goods, computers, wine, restaurant meals • Here the issue is the quality of the good and that can be assessed only after purchase and experience:

14. Advertising as signaling (cont.) • For experience goods advertising could signal high quality even when it otherwise seems without content • producer is better informed of true quality than buyer • makers of high quality goods want to inform consumers • they want repeat purchases • if high quality good is tried once, the consumer will continue to buy • low quality goods will not earn repeat purchases—dissatisfied consumers will not come back • Nelson argued that this leads to an equilibrium in which only makers of high-quality goods will advertise. Why?

15. Advertising as signaling (cont.) • Nelson’s argument is based on the following logic • Advertising in the current period incurs an immediate cost • The return to this investment comes mainly from the extra future sales it generates as consumers come back again and again • For experience goods, whether consumers come make repeat purchases depends on how the good worked the first time

16. Advertising as signaling (cont.) • advertising could “fool” consumers into trying a product that the manufacturer knows is low quality but the manufacturer also knows that these consumers will not be back • So a low quality good cannot earn the extra margin from repeat purchases necessary to make advertising worthwhile • Consumers will be back to buy a high quality good • So a high quality good can earn the extra margin from repeat purchases necessary to make advertising worthwhile • So only high-quality goods exhibit high advertising levels

17. Advertising as signaling (cont.) • If Nelson’s argument is correct, then the very fact that a firm advertises signals high quality • Nelson’s argument suggests that firms may want to publicize just how expensive their advertising is. But we rarely if ever observe such behavior • Further, Nelson’s argument has run into other both theoretical and empirical obstacles • Theoretical: low quality goods may be much cheaper to make => a firm that advertisesa low quality good may find it worthwhile, because even the returns from tricking consumers into trying it once may be substantial • Empirical; little correlation between advertising and independent measures of quality

18. Advertising as a Complement • Becker and Murphy (1993) have suggested that advertising is best viewed as a complement to consumption • Advertising raises the value of the good consumed acting like a network externality to create crowd appeal: • Consumers like goods that other people know about • The more a brand is advertised and known the more consumers like it • The more they like it, the more they buy it and this may raise its value further

19. Advertising as a Complement • Advertising can make a good more valuable by providing information that enables customers to use the product better • For example, letting consumers know that membership in a resort not only provides access to golf but also to tennis courts may make tourists willing to pay more to stay there • Both the crowd appeal and the information views can explain why consumer goods are more heavily advertised than producer goods and why firms keep advertising the same good long after its introduction

20. Advertising strategically • Advertising is a sunk cost • It can be used in our entry-deterrence games

21. Advertising and Monopoly Power • Assume firm faces downward-sloping demandinverse curve that shifts depending on the amount of advertising  (messages): • MR= MC c at optimal Q* • This condition, in terms of the Lerner Index, LI Where P is the price elasticity of demand

22. Advertising and Monopoly Power (2) • Now consider optimal advertising. At any output Q, more advertising will raise the price P(Q,) • revenue will rise by the price increase times output Q. • Profit maximization requires equating this marginal revenue with the advertising marginal cost T at optimal advertising * • Multiplying each side by */P* and dividing by Q* = Advertising-to-sales ratio

23. Advertising and Monopoly Power (3) • Consider carefully this last equation = Advertising-to-sales ratio • We can rewrite P(Q*,)/ as to obtain Multiply the LHS by Q*/Q*

24. Advertising and Monopoly Power (4) • Elasticity of output demand with respect to advertising: • So, we may write = 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.

25. Advertising and Monopoly Power (5) • The Dorfman-Steiner Condition is the starting point for thinking about the relationship between advertising and market power. It yields several important insights • Lerner Index (P – c)/Pequals 1/P. So we can write the Dorfman-Steiner condition as: Advertising-to-Sales Ratio = ALI – Observed positive correlation between advertising and market power has a theoretical basis BUT the causality is reversed—market power (high LI) induces more advertising – Industries with high responsiveness of sales to advertising (high A) will have high advertising intensity – Advertising similarity across industries and over time is to be expected if A and P are similar

26. Advertising Spending • This is the Dorfman-Steiner result • consistent with a negative relationship between the elasticity of demand and advertising • implies that low price elasticity induces high advertising rather than the other way round • increase in advertising only affects share of revenue spent on advertising if it affects demand elasticity: advertising-to-sales ratio is constant if elasticities are constant • more is spent on advertising if consumers react more to advertising • response is likely to be greater for “convenience goods” • consumers value easily available information • than “shopping goods” • consumers likely to shop around • more spent on advertising experience than search goods

27. Advertising and Competition • Can we extend the Dorfman-Steiner result to markets in which there is competition? • suppose there are “many” very similar firms • then there is likely to be a free-rider problem • each firm tempted to free-ride on others’ marketing efforts • so too little advertising • leads to the need for collaborative marketing efforts: “Drink Milk” • suppose that there are few firms selling differentiated products • then expect stronger incentives to advertise • may find a prisoners’ dilemma effect • so there is a connection between advertising and industry concentration • but this is not a causal relationship

28. Next • Advertising, Competition, and Brand Names