ADVERTISING

Advertising aims to create subjective image differences and hence product differentiation. Product differentiation is a tool to increase profitability by decreasing the elasticity of demand.

Advertising plays a key role in the development of the market strategy Advertising allows firms to provide information directly to consumers. It helps firms to create or increase demand for their products. It allows firms to build a “brand image”. It allows firms to differentiate their products.

Types of Advertising We distinguish between informal and persuasive adveritising. Informational (or informative) adveritisng is designed to provide truthful information about price,location or quality. (Does it?) Empricial evidence suggest that advertising about price (price advertising) results in lower prices.

Do you think that advertising works? Does it change consumer behaviour? As an example: Apple Advertising may help manufacturers take advantage of economies of scale in production and distribution.

Advertising is argued to improve quality. Since manufacturers build a brand image via advertising they try to live up to this image and increase the quality of production. Advertising may be seen as a commitment. In real life we always face imperfect information. Informative advertising increases market demand as more consumers become aware of the product. Informative advertising allows firms to increase demand but at the same time demand becomes more elastic. (Why?)

Persuasive Advertising In the real world advertising is more persuasive rather than informational. The main focus of advertising is to build brand loyalty. Persuasive advertising is designed to influence consumer tastes over a particular product. Persuasive advertising creates/increases market power because it is designed to persuade consumers that there is no/little substitues to their products. Moreover, brand loyalty is an important tool for an incumbent firm to set-up entry barriers.

Informative advertising decreases market power/prices/profits. Persuasive advertising increases market power/prices/profits. So in a social welfare manner persuasive advertising decreases social welfare whereas informative advertising increases it. (Really?)

Cost of advertising (2009 US data-millions of dollars) RankCompanyAdvertising exp. 1Procter and Gamble4189 2Verizon3020 3AT&T2797 4General Motors2215 5Pfizer2097 6Johnson&Johnson2061 7Walt Disney2004 8Time Warner1848 9L’oreal Kraft Foods Nestle Pepsi958 48Coca-Cola722

Advertising and Quality Phillip Nelson (1970,1974) developed a model on advertising. Consider two producers of toothpaste. Both toothpastes contain fluoride and have the Anerican Dental Association seal of approval. But the high-quality toothpaste tastes wonderful and the low quality toothpaste tastes horrible. The costs of production are assumed to be equal. Who has a higher incentive to advertise?

Large advertising expenditures by high-quality toothpaste manufacturer signal consumers that it produces a high quality product. Because only high-quality producers advertise extensively. (Do you agree?)

Welfare Effects of Advertising Does advertising increase or decrease welfare? Dixit-Norman model. They analysed the welfare effects of advertising in monopoly, oligopoly and monopolistic competition. Their conclusions were the same for all markets. We will only consider the monopoly model.

From a social welfare perspective, all monopolists spend too much on advertising. Dixit and Norman showed that this result also holds for oligopoly and monopolistic competition. In this model advertising assumed to be purely persuasive, therefore had no social value. Some criticise the model arguing that informative advertising would have positive impact on social welfare. (Do you agree?)

Another argument is that advertising may positively influence consumer’s utility by making them aware of the product. (Do you agree?)

Dorfman-Steiner Model This model is also constructed for monopoly. In the model, only quantitiy is a function of advertising. Price is independent of advertising.

D-S condition states that the proportion of revenue a firm will spend on advertising is determined by the ratio of advertising elasticity to price elasticity. A monopolist will keep spending on advertising until the point it sets advertising to sales ratio equal to the ratio of the advertising-to-price elasticity. Since this is a monopoly model, market power is high and price elasticty is low so advertising expenditures will be high.

In the D-S model profitability is linked to advertising expentiditures. The question is: Does a monopolist really needs advertising?