Advertising effectiveness and spillover: simulating strategic interaction using advertising 25 th International Conference of the System Dynamics Society Boston, Massachusetts 29 th July to 2 nd August, 2007 Dr. Malcolm Brady Dublin City University Business School

Profit

Costs No fixed costs Cost is linear in quantity ie. no economies or diseconomies of scale

(inverse) Demand p q monopoly a: reservation price b: own price effect (market response) a b = slope

Product differentiation duopoly d: represents the cross price effect d/b: represents the extent of product differentiation Dixit, BJE, 1979

Cournot Nash equilibrium Game theory Strategic interdependency Cournot, 1838; Nash, 1951 …(3)

Advertising Selection of amount of advertising –Optimal amount: Dorfman Steiner Impact of advertising on demand –Shifts demand function to the right ie. changes intercept of inverse demand function –Tilts demand function ie. changes slope of inverse demand function –Friedman Cumulative Interfirm (Spillover) effect Cost of advertising –Reduces profit

Advertising elasticity of demand Price elasticity of demand Dorfman-Steiner Δa i = φ i A i + ρφ j A j i =1,2, j=3 - i Friedman Π = pq – cq - A Profit …(4)

Assumptions Production adjusts instantaneously to demand No lags or delays; no spikes or step changes

The model five stock variables five flow variables ten auxiliary variables eight parameters

Initial and Parameter Values a high volume low price product Unit variable cost c set at $8. The initial reservation price a is set at $25. Own-price effect b is set at Cross-price effect d at

reservation price quantity advertising ++ B1 advertising elasticity R1

reservation price quantity advertising + + R2 price elasticity B2 price + - R3

Two firms: Arrays Two sets of loops exist: one for the firm and one for its rival. Additional interaction loops, generated by equation 3, exist: they are as above but with signs reversed. Additional interaction loops, generated by equation 4, exist: they are as above but all variables except reservation price refer to the rival firm. When advertising is predatory all signs are reversed.

φ 1 = ; φ 2 = 0 φ 1 = ; φ 2 = 0 φ 1 = φ 2 = 0 φ 1 = φ 2 = φ 1 = φ 2 = One firm advertisesBoth firms advertise Neither firm advertises

One firm advertises with spillover φ 1 = ; φ 2 = 0; ρ = 0.1 φ 1 = ; φ 2 = 0; ρ = 0.3 Spillover is predatory φ 1 = φ 2 = ; ρ = -0.3 φ 1 = ; φ 2 =0; ρ = -0.3

Some conclusions Advertising can be an effective competitive weapon and can lead to competitive advantage Bifurcation in industry behavior at threshold levels of advertising effectiveness –Some industries advertise and some do not Spillover –Where advertising is a public good firms are less likely to advertise unless all firms in the industry advertise or firms advertise collectively –EU: Olive Oil Ads/ Ireland: Licenced Vintners Ads –Reduces the impact of advertising –Predatory may be more effective than complementary advertising