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AEM 4550: Economics of Advertising Prof. Jura Liaukonyte LECTURE 6-7: OTHER TYPES OF ADVERTISING

Lecture Plan  Persuaders  Review of Persuasive View of Advertising  Complimentary view  Informative view  Model and Examples  Signaling as Information  “Memory Jamming” view

Persuasive Advertising  The persuasive view holds that advertising alters consumers' tastes and creates spurious product differentiation  The demand for a firm's product becomes more inelastic  Advertising results in higher prices  Such advertising by established firms may give rise to a barrier to entry, which is naturally more severe when there are economies of scale in production and/or advertising differentiation and brand loyalty

Model of Persuasive Advertising $Quantity  MC Demand without advertising Profit **** Demand with advertising

Complementary Advertisement

Complementary View  Associated with the Chicago School  When a firm advertises more, its product becomes more attractive to the consumer  “The household is made to believe – correctly or incorrectly – that it gets a greater utility of the commodity from a given input of the advertised product”  Consumer may value social prestige and advertising thus positions the product so that its consumption provides social prestige Definition Implication   Firms may compete in the same commodity (e.g., prestige) market even though they produce different market goods (e.g., jewelry and fashion) and advertise at different levels.

Complementary vs. Persuasive  The lines between complementary and persuasive are blurred, because it is hard to know whether ads change preferences or are part of consumer’s utility.

Informative Advertising

Informative View  Advertising is attractive to firms as a means through which they may convey information to consumers.  Advertising effectively reduces consumers' search costs, since it conveys information about products.  Advertising may have pro-competitive consequences.  Advertising is a valuable source of information for consumers that results in a reduction in price dispersion  “Chicago School” view.

Model of Advertising as Information  Total of N identical consumers in the market.  Each consumer will buy Q(P) if informed about the product.  Advertising informs consumers about the existence and/or usefulness of the product.  Number of consumers informed depends on the amount spent on advertising.

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

Model of Advertising as Information  As ad expenditures increase, so does demand and profit.  Firms select advertising to maximize profit, i.e., where MR from ads is equal to the MC of ads.  In this model, higher levels of advertising do not lead to higher prices.  Advertising does increase total consumer surplus as well as firm profit, since advertising increases the number of consumers that get a surplus.

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

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

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

Comparison  Higher advertising leads to higher demand for each consumer, which leads to higher prices. Persuasive/Complementary ModelInformative 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.

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.

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.

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.

Signaling as Information  3 reasons why advertising may provide indirect information about experience goods. 1. 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.

Signaling as Information 2. 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.

Signaling as Information 3. 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

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

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

Memory Jamming View of Advertisement

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.

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.

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.

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

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

Example: Breakfast Cereal Industry

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

Example: Soft Drink Industry

Memmory 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

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