LECTURE 3: ADVERTISING ELASTICIES

1. LECTURE 3:ADVERTISING ELASTICIES AEM 4550:Economics of AdvertisingProf. Jura Liaukonyte

2. Plan of the Lecture • Other Elasticities • Advertising Elasticity • Measures of Market Concentration • Relationship between Advertising and Market structure: • Dorfman-Steiner Condition • Optimal Advertising levels • Advertising to sales ratios across different industries • Product differentiation and Advertising

3. Other Demand Elasticities • Income Elasticity of Demand • Measures how much quantity demanded changes with a change in income

4. Values for Income Elasticity (EI) • Sign indicates normal or inferior  EI>0 implies normal good. EI<0 implies inferior good. • Normal goods may be necessity or luxury.

5. Cross-Price Elasticity of Demand Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good Other Demand Elasticities

6. Other Demand Elasticities • Complements: Cars and Tires • Cross-price elasticity of demand is negative • Price of cars increases, quantity demanded of tires decreases • Substitutes: Butter and Margarine • Cross-price elasticity of demand is positive • Price of butter increases, quantity of margarine demanded increases

7. Example: The Cross-Price Elasticity of Demand for Cars • Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995), 841-890.

8. Magnitude shows size of shift in Demand (assume Psubst increases) EXY>1 PX PX D’ D’ D D QX QX EXY<1

9. Price Elasticity of Supply • Measures the sensitivity of quantity supplied given a change in price • Measures the percentage change in quantity supplied resulting from a 1 percent change in price

10. MR = MC • Profit is p(q) = TR(q) - TC(q) • Profit maximization: dp/dq = 0 • This implies dTR(q)/dq - dTC(q)/dq = 0 • But dTR(q)/dq = marginal revenue • dTC(q)/dq = marginal cost • So profit maximization implies MR = MC

11. Monopoly (cont.) • Derivation of the monopolist’s marginal revenue $/unit Demand MR Demand: P = A - B.Q Total Revenue: TR = P.Q = A.Q - B.Q2 Marginal Revenue: MR = dTR/dQ MR = A - 2B.Q With linear demand the marginal revenue curve is also linear with the same price intercept but twice the slope of the demand curve Quantity

12. Lerner Index • Lerner Index • L = (p - MC)/p = 1/|EP| • The higher the number, the more pricing power the firm has. • Mark-up power reflects monopoly power. • PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark-up will increase.

13. Advertising Elasticity • Measures the sensitivity of demand given a change in advertising

14. Advertising Elasticity • Ad-inelastic demand curve: Demand does not shift much from advertising. • Example: concrete: Consumers’ purchasing decisions are mostly based on price and related terms of sale. • Ad-elastic demand curve: Demand is relatively responsive to advertising. • Example: soda: Consumers’ purchasing decisions can be easily swayed by effective advertising campaigns.

15. Advertising Elasticity • Two key results from advertising • The marginal gain from advertising expenditures is greater the more sensitive the demand curve is to advertising expenditures. • Firms should advertise more when the demand curve is more sensitive to advertising expenditures.

16. Market Concentration • Industries have very different structures • Numbers and size distributions of firms • Ready-to-eat breakfast cereals: high concentration • Newspapers: low concentration • How best to measure market structure • Concentration ratio • Herfindahl-Hirschman Index (HHI) • Lerner Index (LI) • Let’s look at each of them:

17. Industry Concentration • Four-Firm Concentration Ratio • The sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales • Herfindahl-Hirschman Index (HHI) • The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000 S wi2, where wi = Si/ST.

18. Measure of concentration • Compare two different measures of concentration: Firm Rank Market Share Squared Market (%) Share 1 25 625 2 25 625 3 25 625 4 5 25 5 5 25 6 5 25 7 5 25 8 5 25 Concentration Index

19. Measure of concentration • Compare two different measures of concentration: Firm Rank Market Share Squared Market (%) Share 1 25 25 625 2 25 25 625 3 25 25 625 4 5 5 25 5 5 25 6 5 25 7 5 25 8 5 25 H = 2,000 Concentration Index CR4 = 80

20. Concentration index is affected by, e.g. merger Firm Rank Market Share Squared Market (%) Share 1 25 25 Market shares change 625 Assume that firms 4 and 5 decide to merge 2 25 25 625 3 25 25 625 4 5 5 } } } 25 5 5 25 6 5 25 7 5 25 8 5 25 Concentration Index CR4 = 80 H = 2,000

21. Concentration index is affected by, e.g. merger Firm Rank Market Share Squared Market (%) Share 1 25 25 Market shares change 625 Assume that firms 4 and 5 decide to merge 2 25 25 625 3 25 25 625 4 5 5 } } } 25 100 10 5 5 25 6 5 25 7 5 25 8 5 25 Concentration Index CR4 = 80 H = 2,000

22. Concentration index is affected by, e.g. merger Firm Rank Market Share Squared Market (%) Share 1 25 25 625 2 25 25 625 3 25 25 625 4 5 5 } } } 25 100 10 5 5 25 6 5 The Concentration Index changes 25 7 5 25 8 5 25 Concentration Index CR4 = 80 85 H = 2,000 2,050

23. HHI • The Herfindahl-Hirschman Index – the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50) • In perfect competition, the HHI is small • In monopoly, the HHI is 10,000 (100 squared) • A popular measure with the Justice Dept in the 1980’s • HHI < 1000 characterized competitive markets • HHI > 1800 would bring Justice Dept challenge to proposed mergers • e.g. The cigarette industry is highly concentrated with only 8 firms and a Herfindahl-Hirschman Index (HH1) of 2623

24. Example: Candy and Chocolate Industry

25. Candy v. Chocolate CANDY HHI (for top 4) = 1141 CR ₄ = 59% Medium level concentration ->Concentration is increasing! 1,039 businesses overall!! CHOCOLATE HHI (for top 4)= 2941.81 Cr ₄ = 78.1% High level of concentration 518 Businesses overall!!

26. CR₄ and HHI: Candy Industry • The HHI for just the top 4 companies in the industry is 2941.81. • The CR ₄ for the industry is 78.1%. • Therefore, the industry is highly concentrated with only a few major firms holding a majority of the market share. HHI = 49.5²+21.6²+4²+3²=2941.81 CR ₄ = 49.5 + 21.6 + 4 + 3= 78.1% *Hershey and Mars Inc. alone hold 71.1% of the market share. -Many mergers occur.

27. Example Credit Card Industry

28. Market Definition • All Credit Lending Institutions with their own card • 27.2% J.P. Morgan Chase & Co. • 19.2% Bank of America Corporation • 18.9% Citigroup Inc. • 17.2% American Express Company • 4.0% Capital One • CR4: 83.2 • HHI: 1810-1850 • Total Number of Companies: 192

29. What is a market? • No clear consensus • The market for automobiles • Should we include light trucks; pick-ups SUVs? • The market for soft drinks • What are the competitors for Coca Cola and Pepsi? • With whom do McDonalds and Burger King compete? • Presumably define a market by closeness in substitutability of the commodities involved • How close is close? • How homogeneous do commodities have to be?

30. Fast-Food Outlets McDonald’s Burger King Wendy’s

31. Market Performance • Market structure is often a guide to market performance • But this is not a perfect measure • Can have near competitive prices even with “few” firms • Measure market performance using the Lerner Index P-MC LI = P

32. Lerner Index • L = (p - MC)/p = 1/|EP| • Lerner Index is bound between (0,1) • Closer to 1 the more pricing power the firm has. • Mark-up power reflects monopoly power. • PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark-up will increase.