LECTURE 7: OTHER TYPES OF ADVERTISING

1. LECTURE 7:OTHER TYPES OF ADVERTISING AEM 4550:Economics of AdvertisingProf. Jura Liaukonyte

2. Lecture Plan • HW2 • Exam 1 • Informative View • Memory Jamming View • Empirical Studies of Advertising Effectiveness • Advertising and Media Planning • Definitions • Costs • Upfront Market

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

4. Example: Auto Industry Interaction between Persuasive and Informative advertising

5. Manufacturers vs Dealers • Brand Advertising: advertising geared towards brand positioning and communication of product attributes and brand benefits • Price Advertising: advertising that informs consumers about price and availability of a brand "Manufacturer Advertising and Dealers Association Advertising"

6. Manufacturers vs Dealers • Manufacturers often use brand advertising • Ex: “Ford Tough” or “V-8 Engine” • Dealers often use price advertising • Ex: “$2,000 rebate” or “Labor Day Sales Event” "Manufacturer Advertising and Dealers Association Advertising"

7. Manufacturers vs Dealers • Manufacturer Brand Advertising (MBA) and Dealers’ Price Advertising (DPA) interact positively • This suggests that brand advertising and price advertising may work together when they are sent by different channel members • Attribution Theory: when consumers accredit auto dealers’ discount advertisements to addressing competition in the industry, the price advertising increases purchase intent. "Manufacturer Advertising and Dealers Association Advertising"

8. Manufacturers vs Dealers • Manufacturer Brand Advertising (MBA) and Manufacturer Price Advertising (MPA) interact negatively. • This suggests that brand advertising and price advertising do not complement each other when they come from the same channel. • Unlike Dealers’ Price Advertising, when manufacturers use price advertising, consumers connect a lower price to a defect in the product. • This is consistent with the informative view of advertising because advertising about price makes demand more elastic. "Manufacturer Advertising and Dealers Association Advertising"

9. Manufacturers vs Dealers • When Dealers advertise about price, it increases consumers’ intent to purchase. • When manufacturers advertise about price, it decreases consumers’ intent to purchase. "Manufacturer Advertising and Dealers Association Advertising"

10. Manufacturers vs Dealers • As a result, brand advertisements by manufacturers and price advertisements by dealers should be coordinated to appear at similar times. "Manufacturer Advertising and Dealers Association Advertising"

11. Empirical evidence: Setting • In the 1960s, considerable variation existed across US with respect to the legal treatment of advertising in the eyeglass industry • Some states prohibited all advertising • Some states prohibited price advertising but allowed non-price advertising • Some states had no restrictions • This variation provides a natural experiment

12. Empirical Evidence: • Eyeglass prices were substantially higher in states that prohibited all advertising than in states that had no restrictions • The association between price advertising and lower prices is striking and directly supports the informative view

13. Other Studies • Cady (1976) considers the U.S. retail market for prescription drugs in 1970 • Retail prices are significantly and positively related to advertising restrictions • Maurizi and Kelly (1978) compare retail gasoline prices across major cities • Both the mean and variance of prices are lower in states where price advertising is allowed • Schroeter, Smith and Cox (1987) use survey data for the routine legal service market in 17 U.S. metropolitan areas • Evidence that price–cost ratios are lower when area-wide advertising intensity is greater • These studies all support the informative view

14. Comparison • Persuasive/Complementary Model: • Higher advertising leads to higher demand for each consumer, which leads to higher prices. • Informative 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.

15. Signaling as Information • 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.

16. Signaling as Information • Nelson, 1970 begins with a simple question: • How, exactly, does advertising provide information to consumers? • The informative content of advertising is clear, when the advertisement contains direct information as to the existence, location, function or price of a product. • But what about all of the advertising that does not contain direct information of this kind? Is it persuasive? • Nelson argues rather that such advertising still plays an informative role, although the role is indirect.

17. Signaling as Information • To develop this argument, Nelson (1970) makes a distinction between search and experience goods. • Recall, a search good is one whose quality can be determined prior to purchase (but perhaps after costly search), • The quality of an experience good can be evaluated only after consumption occurs. • Indirect information contained in advertising is especially important for experience goods.

18. Signaling as Information • 3 reasons why advertising may provide indirect information about experience goods. • Signaling-efficiency effect. • The demand expansion that advertising induces is most valuable to efficient firms, • By advertising, a firm signals that it is efficient, which implies in turn that it offers good deals.

19. Signaling as Information • Match-products-to-buyers effect. • Consumers may have heterogeneous tastes, and it may be difficult to efficiently match products and buyers. • A seemingly uninformative ad can assist in this process, since a firm has the incentive to direct its advertising toward the consumers that value its product the most.

20. Signaling as Information • Repeat-business effect. • Ads may remind consumers of their previous experience with the product, and such recollections are of more value to sellers of high-quality goods. • Even new consumers may draw a positive association between advertising and quality, and advertising thus may signal quality. • Similar to “Memory Jamming” View

21. Signaling and Search Products • Ads can provide indirect information here as well. • Recall signaling-efficiency effect: even if a search good advertisement contains no direct information, the fact that the good is advertised may suggest that the seller is efficient • However, search goods offer greater potential for direct information transmission through advertising • I.e., ads for experience qualities is dominantly indirect information and advertising for search qualities is dominantly direct information

22. Evidence of the Signaling Theory • Advertising intensity is higher for experience goods • The ratio of TV to magazine advertising is significantly higher for experience goods • Search goods are especially conducive to the transfer of direct information • Advertising intensity is higher for non-durable experience and lower-priced experience goods • For major purchases, a consumer relies more on WOM, whereas for more frequent, low-cost purchases, a consumer relies on advertising as a source of indirect information

23. Memory Jamming View of Advertising

24. Memory Jam • Why do familiar brands such as Coca-Cola and McDonald’s advertise so heavily? • With the average American drinking 10 gallons of Coca-Cola each year, it’s hard to believe there is much left for most consumers to learn about what’s inside the can. • Advertising might also influence the way consumers encode and recall their consumption experiences.

25. Memory Jam • Psychological studies show that people can quite easily forget the origin of a memory. • E.g. the stranger’s face is familiar, the individual cannot remember why. • When people don’t directly recall the source of a memory, they use what they know to fill in the gaps.

26. Memory Jam: Experiment • Researcher gave participants orange juice spiked with salt and vinegar. • Results showed that people who watched advertisements for the juice after the taste test remembered the juice as tasting good. • Even though what they actually consumed was designed to taste terrible. • Ads changed recollection of the sensory experience of tasting the juice, even in the very short-term.

27. Memory Jamming View: Formalized • Economic theory of advertising based on limited consumer memory • Consumers learn through experience: how much they enjoy consuming a firm’s product • Each consumer stores in memory the utility he has received from consuming the product during each past experience • At the point of purchase, the consumer recalls the utility of these experiences to memory

28. Memory Jamming View: Formalized • The firm can use advertising to change the likelihood that the consumer will remember a favorable consumption experience • Consistent with a large literature in the psychology of memory

29. Example: Breakfast Cereal Industry

30. Memory Jamming • Average preschooler sees 642 ads/year on TV • Memorable slogans • Lucky Charms: They’re magically delicious! • Paired with creative cartoons- easily recall figures and mascots

31. Student Example Soft Drink Industry

32. MEMORY JAMMING • Need for the players to advertise heavily • Reminds the experience more than what is inside the can • Changes the way a consumer remembers an experience • Coca-Cola’s main type of advertising

33. Combative Advertising • Combative advertising, a characteristic of mature markets, is defined as advertising that shifts consumer preferences towards the advertising firm, but does not expand the category demand. • Not about influencing the consumer preferences, but rather about the supply side and advertising • Redistributes consumers among brands. If the real differences between brands are modest, then combative advertising may be excessive • Basis of Prisoner's dilemma in advertising

34. Prisoner's Dilemma

35. Advertising Wars • The prisoner's dilemma applies to advertising • All firms advertising tends to equalize the effects • Everyone would gain if no one advertised • Advertising WarsTwo firms spend millions on TV ads to steal business from each other. Each firm’s ad cancels out the effects of the other, and both firms’ profits fall by the cost of the ads.

36. 1964 1970 Cigarette Advertising on TV • All US tobacco companies advertised heavily on TV • Surgeon General issues official warning • Cigarette smoking may be hazardous • Cigarette companies fear lawsuits • Government may recover healthcare costs • Companies strike agreement • Carry the warning label and cease TV advertising in exchange for immunity from federal lawsuits.

37. Strategic Interaction • Players: Reynolds and Philip Morris • Strategies: Advertise or Not Advertise • Payoffs: Companies’ Profits • Strategic Landscape: • Each firm earns $50 million from its customers • Advertising costs a firm $20 million • Advertising captures $30 million from competitor • How to represent this game?

38. PAYOFFS Representing a Game PLAYERS STRATEGIES

39. What to Do? If you are advising Reynolds, what strategy do you recommend?

40. Solving the Game • Best reply for Reynolds: • If Philip Morris advertises: • If Philip Morris does not advertise:

41. Dominance • A strategy is dominantif it outperforms all other choices no matter what opposing players do • Games with dominant strategies are easy to play • No need for “what if …” thinking

42. DominanceA Technical Point • Strict Dominance: Advertise is strictly dominant forReynoldsif: • Profit (Ad , Ad) > Profit (No , Ad) • Profit (Ad , No) > Profit (No , No)

43. Dominance COMMANDMENT If you have a dominant strategy, use it. Expect your opponent to use her dominant strategy if she has one.

44. Prisoner’s Dilemma • Both players have a dominant strategy • The equilibrium results in lower payoffs for each player Optimal Equilibrium

45. Equilibrium Illustration The Lockhorns

46. Cigarette Advertising • After the 1970 agreement: • Cigarette advertising decreased by $63 million • Industry Profits rose by $91 million • Prisoner’s Dilemma • An equilibrium is NOT necessarily efficient • Players can be forced to accept mutually bad outcomes • Bad to be playing a prisoner’s dilemma, but good to make others play

47. Empirical Studies of Advertising Effectiveness

48. Advertising–Sales Relationship • Lambin (1976) uses various sales, quality, price and advertising data • 107 individual brands from • 16 product classes • 8 different Western European countries • How changes in the advertising expenditures for one brand may affect the current sales of that brand and rival brands? • Evaluate goodwill effects and the rival-brand response that an advertising expenditures may induce

49. Lambin (1976) Findings • Brand advertising has a significant and positive effect on the brand's current sales and market share • Evidence for advertising's goodwill effect • The quantitative impact of advertising on (current and future) sales is limited: • Sales appear more responsive to price and product-quality selections • Firm's sales and market share are negatively related to rival advertising • Evidence of what?

50. Advertising Goodwill • Clarke (1976) identifies a “data-interval-bias” problem: • The use of annual advertising data when the effects of advertising on sales depreciate over a shorter period of time can lead to biased estimates of the depreciation rate. • “The duration of cumulative advertising effect on sales is between 3 and 15 months; thus this effect is a short-term (about a year or less) phenomenon.” • More recently, several studies offer further evidence that the effect of advertising on sales is often largely depreciated within a year (if not less). • Latest studies: Beyond 3 months = miniscule effect.