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AEM 4550: Economics of Advertising Prof. Jura Liaukonyte LECTURE 7: OTHER TYPES OF ADVERTISING

Lecture Plan  HW2  Exam 1  Prisoner's Dilemma  Empirical Studies of Advertising Effectiveness  Advertising and Media Planning  Definitions  Costs  Upfront Market

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

Prisoner's Dilemma

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 Wars Two 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.

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

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?

Representing a Game PLAYERS STRATEGIES PAYOFFS Philip Morris No AdAd Reynolds No Ad 50, 50 20, 60 Ad 60, 20 30, 30

What to Do? If you are advising Reynolds, what strategy do you recommend? Philip Morris No AdAd Reynolds No Ad 50, 50 20, 60 Ad 60, 20 30, 30

Solving the Game  Best reply for Reynolds:  If Philip Morris advertises:  If Philip Morris does not advertise: Philip Morris No AdAd Reynolds No Ad 50, 50 20, 60 Ad 60, 20 30, 30

Dominance  A strategy is dominant if 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

Dominance A Technical Point  Strict Dominance: Advertise is strictly dominant for Reynolds if:  Profit (Ad, Ad) > Profit (No, Ad)  Profit (Ad, No) > Profit (No, No)

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

Prisoner’s Dilemma  Both players have a dominant strategy  The equilibrium results in lower payoffs for each player No AdAd No Ad 50, 50 20, 60 Ad 60, 20 30, 30 Equilibrium Optimal

Equilibrium The Lockhorns

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

Empirical Studies of Advertisement Effectiveness

Advertising Goodwill  Intangible stock of goodwill that can be increased by the advertising efforts.  “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.

Advertising–Sales Relationship  Meta analysis 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

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?

Sales Advertising Expenditures A.Concave-Downward Response Curve Sales Advertising Expenditures Range A Range B Range C B.S-Shaped Response Function High Spending Little Effect Initial Spending Little Effect Middle Level High Effect Threshold Saturation Point Sales Response Models

Sales Response Model Threshold Effect Saturation Effect Sales Adv Expenditures

Overall Advertising Impact (Gerard J. Tellis)  The average sales-to-advertising elasticity is 0.1  Higher for new products than established products  For Europe than the United States  For durables than nondurables  For print than TV  Advertising elasticity is also lower in models that use disaggregate data and include advertising carryover, quality, or promotion

Determinants of Advertising Impact (Demetrios Vakratsas)  Advertising impact depends on the product category.  Specifically, advertising elasticities are as much as 50% higher for durables as for nondurables.  Advertising is more effective for experience than for search products.

Advertising Impact and Competition (Demetrios Vakratsas)  Higher competitive intensity (clutter) will result in lower advertising effectiveness.  Competitive advertising may reduce elasticities by as much as 50%.

Advertising Reference Price (Dhruv Grewal and Larry D. Compeau)  The presence of an advertised reference in a price offer enhances perceptions of value  Lowers their intention to search for a lower price.

TV Advertising Effect  The average TV advertising to sales elasticity is 0.11 for established consumer products.  It is higher for tests after 1995 than those before.  There is a high variability in effects around these average elasticities. Some tests had elasticities over 0.5 and others were below

Advertising and Business Cycles  Advertising is more sensitive to business-cycle fluctuations than the economy.  Average co-movement elasticity is1.4.  Hence, a 1% increase in the cyclical component of GDP translates, on average, into a 1.4% increase in the cyclical component of the demand for advertising.  The extent of this sensitivity varies systematically across countries.  When companies tie advertising spending too tightly to business cycles, they experience higher losses: 1. A lower long-term growth of the advertising industry 2. A higher private-label share 3. Lower stock prices

Empirical Studies 1. A firm's current advertising is associated with an increase in its sales, but this effect is usually short lived. 2. Advertising is often combative in nature.  An increase in advertising by one firm may reduce the sales of rival firms, and rivals may then react with a reciprocal increase in their own advertising efforts. 3. The overall effect of advertising on primary demand (size of the pie) is difficult to determine and appears to vary across industries.

Firm Specific Factors  When assessing the goodwill impact of advertising, it is important that firm-specific factors not be omitted.  Recall Nelson’s theory:  It may be that advertising affects initial sales but that long-term sales are driven by firm-specific factors, like product quality.  Given that higher-quality firms may advertise more, the effects of advertising on future sales may be overstated in an empirical analysis that omits product quality.  Kwoka (1993) examines the determinants of model sales in the U.S. auto industry, finding that the effect of advertising is short-lived while product styling has a much longer impact.

Advertising and Entry  Advertising as a response of incumbent firms to entry:  Alemson's (1970) studies Australian cigarette industry: new entrants advertise to gain market share and induce increased advertising by incumbents, who seek to maintain market share.  Thomas (1999) studies the ready-to-eat cereal industry and reports that incumbent firms often respond to entry with advertising, in order to limit the sales of new entrants.  Cubbin and Domberger (1988) examine 42 consumer-goods industries and report evidence that dominant incumbent firms in slow-growth markets often respond to entry with an increase in advertising.

Advertising and Industry Demand  Empirical studies suggest that advertising may increase primary demand in some industries but not others.  Positive relationships between industry advertising and sales:  UK cigarette industry  U.S. orange market  U.S. auto industry  U.S. milk market  No effect:  U.S. beer market  UK instant-coffee market

Advertising and Brand Loyalty  No clear consensus.  The studies do not provide strong evidence that advertising consistently increases brand loyalty or stabilizes market shares.

Brand Loyalty  Recall Persuasive view:  The direct effect of advertising is that brand loyalty is created and the demand for the advertised product becomes less elastic.  Lack of high detail data – need exposure and brand-purchase data as well as the advertising and pricing behaviors of rival firms.  Partly remedied by advent of supermarket scanner data.  2 ways to test for brand loyalty:  Estimate demand functions for individual brands, in order to see if consumers exhibit more “inertia” in highly advertised markets.  See if the estimated price elasticities are lower in magnitude in product groups with high advertising intensity.  Infer the extent of brand loyalty, by further examining the relationship between advertising and market-share stability.