Economics of Management Strategy BEE3027 Lecture 3 15/02/2008

Recap Last week we looked at: –Property-rights motivation for existence of firms; –Team production; –Compensation schemes; –Coordination problem in production.

This week We will look at: Strategic interaction in oligopolies: –The role of managers and strategic delegation. Advertising.

Advertising Advertising is an integral part of our lives. It is also one of the largest industries: –Global spending on advertising in 2005: $400bn Economists see advertising as a means to transmit information about a good or service. However, there are 2 key aspects to it: –Information receivers don’t pay for information; –Information is transmitted by the seller.

Advertising Advertising expenditure is usually measured as the ratio of adv expenditure to sales. This ratio varies drastically across industries: We will look at advertising from two different perspectives: –Persuasive advertising; –Informative advertising.

Persuasive Advertising Models of persuasive advertising assume that advertising enhances consumer preferences for a given product. Hence, higher expenditures on advertising result in increased demand for a product. Typically you’d think of the effect of advertising as a rightward shift in the demand curve.

Persuasive Advertising

Firm must balance out the effects on demand of a shift in demand due to advertising expenditures and the impact of a change in price. The balance is found when Markets sensitive to advertising will have higher advertising-to-sales ratios

Informative advertising In the real world, there are a number of different products which cater to our needs. However, it is difficult to know all the products out there and make an informed choice. Advertising can be seen as a means to inform consumers of the existence of a product. In this sense, it may be socially productive to engage in advertising activities.

Informative advertising Consider the case of a single consumer, in a market with a single good. –The price of this good is fixed at p. –The benefit the consumer gains from the good is m. Hence, the consumer’s utility function is: m – p if he purchases the good; 0 otherwise

Informative advertising There are two firms selling this product. –There are zero production costs Firms can only use advertising as a tool to boost sales. –Advertising has a cost equal to A Therefore, the consumer may receive a total of 0, 1 or 2 ads from the two companies.

Informative advertising If the consumer receives no ads, he will not buy the product. If the consumer only receives on ad, he will buy the product from that company. If the consumer receives both ads, he will pay p/2 to both firms. –This is equivalent to flipping a coin to determine which firm to buy the product from.

Informative advertising Therefore, the payoff to firm i is: p – A if only firm i’s ad is received; p/2 – A if both firms’ ads are received; – A if firm i sends an ad but consumer does not receive it; 0 if firm i does not advertise The fact that firms create ads does not imply consumers will see them.

Informative advertising The probability that the consumer will see the ad is the same for both firms and is equal to δ, where 0 < δ < 1. So, the expected profit for firm i is: δ(1- δ)(p-A) + δ²(p/2-A) – (1- δ)A if 2 firms advertise; δ(p-A) – (1-δ)A if only firm i advertises; 0 if firm i does not advertise.

Informative advertising What is the social optimal level of advertising? –The social planner wants to maximise consumer surplus and total profit Expected welfare is: δ(2- δ )m – 2A if two firms advertise; Δm – A if one firm advertises; 0 if no firm advertises

Informative advertising Suppose that p would be set to its maximum level, such that consumer surplus is zero –i.e. p = m –This way, welfare = profits and our analysis is made much simpler! It is therefore socially optimal for two firms to advertise if: δ(2- δ )p – 2A > δp – A  p/A > 1/[δ(1- δ)]

Informative advertising So, there are combinations of p/A and δ in which: –It is profitable for each firm to advertise; –But where it is socially inefficient to do so.

Informative or persuasive? So far, we’ve covered two different approaches to advertising. These models assume that either: –Consumers are aware of the product, but need “convincing”; or –Consumers are unaware of the product, but would buy it once they know about it. In reality, some consumers will not be informed, while others will. In the latter case, it is likely some consumers will prefer one product over others.

Targeted advertising The bottom line is that firms will be unable to successfully reach the entire set of consumers. Firms must instead target a subset of consumers for which their advertising appeals. –It is almost impossible to identify product attributes which are universally appealing; –Advertising is costly, hence there will diminishing returns to scale; –Having a differentiated product gives firms market power, thus implicitly segmenting their demand.

Targeted advertising Consider 2 firms, 1 and 2 producing differentiated brands of the same product, brand 1 and brand 2. There are two types of buyers: –N inexperienced consumers; –E experienced consumers. E is divided into: –θ consumers who prefer brand 1; –(1-θ) consumers who prefer brand 2.

Targeted advertising In this model, a firm may either use: –Persuasive advertising, P, or –Informative advertising, I. P only affects inexperienced consumers. So if firm 1 chooses P: –If firm 2 chooses I, firm 1 gets N consumers; –If firm 1 also chooses P, both firms get N/2 consumers. I only affects experienced consumers. –If firm 1 chooses I, it gets θE consumers; –If firm 2 chooses I, it gets (1- θ)E consumers.

Targeted advertising Firm 2 PI Firm 1 PN/2, N/2N, (1- θ)E IθE, NθE, (1- θ)E

Targeted advertising Any of the 4 outcomes can be an equilibrium of this game depending on certain market conditions. (P,P) is an equilibrium (i.e. firms only target inexperienced consumers) if: –N > E; – (I,I) is an equilibrium (i.e. firms only target inexperienced consumers) if –E > 2N; –

Targeted Advertising If brand 1 is unpopular among experienced users, firm 1 will use persuasive advertising and firm 2 will use informative advertising. (P,I) is an equilibrium if: –

Targeted Advertising If brand 1 is sufficiently popular among experienced users, firm 1 will use informative advertising and firm 2 will use persuasive advertising. (I,P) is an equilibrium if –