1. Advertising Basics n Provided by someone with a definite agenda, but not necessarily the producer of the product. n Provided free -- you do not pay directly for the advertising. n Not free to the firms, so there must be some benefit to them -- increased profit. n In general, industries with highest levels of advertising also consumer good industries with highest profits.

2. Advertising as Product Differentiation n Advertising as a wasteful, rent-seeking behavior. n Once products are differentiated in the eyes of the consumer, the firms gain market power. u Classic monopolistically competitive model. u Price will rise above marginal cost. u There will be deadweight loss.

3. Monopolistic Competition

4. Advertising as a barrier to entry n If an industry is characterized by a high level of advertising, potential entrants must invest heavily in advertising to “launch” new products. u Fixed costs of entry increase, increasing scale at which firm must compete in order to become profitable. u May decrease the number of firms in an industry, thus increasing price.

5. Advertising as part of a “prisoner’s dilemma”

6. Model of Advertising as a “Capture the Consumer” Game n Consumers know about a product category in general, but are not well informed about the characteristics of individual products. u Example: don’t know where all the grocery stores in Williamsburg are located. n Firms advertise to inform consumers, but only some consumers “hear” the advertisements.

7. “Capture the Consumer” Game Con’t n Assume two firms, X and Y. n Probability that any customer hears an advertisement from firm i is  i. n Thus (  x *(1-  y )) consumers know about X, (  y *(1-  x )) know about Y,  x  y are perfectly informed, (1-  x )(1-  y ) are uninformed.

8. “Capture the Consumer” Game Con’t n Firm only competes on price for perfectly informed consumers, so price is higher than it would be if all firms were perfectly informed. n As firms try to reach more consumers, they must spend more money on advertising (diminishing returns to advertising). n Higher price in part funds advertising.

9. Positive Views on Advertising n Advertising can be a “good” itself with a positive value to consumers. n Advertising can provide information and lower a consumer’s search costs. u In states with restrictions on price advertising (prescription drugs, alcohol) prices are generally higher. n Advertising can signal quality.

10. Advertising as a Complement to Monopoly Power n Advertising can help increase the value of a good. n Advertising is a complement to primary good; consumers value joint consumption of the primary good and the ad. n Firms advertise to increase the demand for the primary good. n This theory applies to a broad range of goods.

11. Model of Advertising and Crowd Appeal n Total of N consumers in the market. n Each consumer will buy only one unit of the primary good. n Each consumer has a different value, v i, for the primary good. n Advertising increases each consumer’s value by the same factor, , regardless of their initial value. Thus each consumer’s value with advertising is  * v i.

12. Model of Advertising and Crowd Appeal $ Quantity  MC Demand without advertising Profit ** Demand with advertising

13. Model of Advertising and Crowd Appeal, con’t n Increase in consumers’ willingness to pay, , is a function of the amount spend on advertising, s. n As s increases,  (s) increases, as does consumer demand and profit. n Firms will select the level of advertising that maximizes profit, i.e., the level of s where the marginal revenue from s is equal to the marginal cost of s.

14. Model of Advertising and Crowd Appeal, con’t n In this model, higher levels of advertising lead to higher prices because the advertising increases the consumers’ willingness to pay. n Also, advertising can increase consumer surplus as well as firm profit, since advertising increases a consumer’s value.

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

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

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

18. Comparison of these two models n Complementary Goods Model: u Higher advertising leads to higher demand for each consumer, which leads to higher prices. n Brand Recognition Model: u Higher levels of advertising leads to more consumers but not a higher demand for each consumer, so prices are not affected by advertising levels.

19. More About the Optimal Level of Advertising n Use the Advertising as Information model. n Assume an informed consumer has a demand of q = a-bP. n The number of informed consumers depends on the level of advertising, s. n Total demand Q = n(s)(a-bP). n Assume that the firm has a constant marginal cost of production of c and a constant marginal cost of advertising, .

20. More About the Optimal Level of Advertising, con’t n If total demand Q = n(s)(a-bP), then the inverse demand is P = a/b - Q/[b*n(s)] which we can rewrite as P = A - BQ/n(s). n Profits are  =(A-BQ/n(s)-c)Q - s . n First find Q* given s by taking the derivative of profit w.r.t. Q and set = 0. n A-2BQ/n(s) - c = 0  Q* = (A-c)*n(s)/2B. n So P*=A-B[(A-c)*n(s)/2B]/n(s) = (A+c)/2.

21. More About the Optimal Level of Advertising, con’t n Assume the firm increases s by one unit. What happens to profit? n Quantity sold will increase since Q* = (A-c)*n(s)/2B. Call this amount Q s. n P* is independent of s, so for the additional units sold, firm gets (P* - c). n So MR from one more unit of s is Q s (P*-c). n The firm will advertise until  = Q s (P*-c).

22. More About the Optimal Level of Advertising, con’t n Remember from the lecture on price discrimination that the price-cost margin for a monopolist is a function of demand elasticity. n (P*-c)/P* = 1/  (Lerner index) n Use this with the condition for the optimal amount of s:  = Q s (P*-c). n Rearrange to get:  = Q s (P*/  )

23. More About the Optimal Level of Advertising, con’t n So now we have  =Q s (P*/  )   /P* = Q s / . n Multiply both sides by s*/Q* to get: s*  /P*Q* = s*Q s /Q* . n The l.h.s. is just advertising expenditures/ sales revenue (adv. to sales ratio). n The r.h.s. can be broken down into two parts: s*Q s /Q* and . n The first is the elasticity of demand w.r.t. adv. and the second is price elasticity.

24. More About the Optimal Level of Advertising, con’t n So the optimal advertising to sales ratio should be the same as the ratio of the elasticity of demand w.r.t to advertising to the elasticity of demand w.r.t. price. n This is known as the Dorfman-Steiner condition. n The more price inelastic demand is, the more should be spent on advertising. n The more advertising elastic demand is, the more should be spent on advertising.

25. More About the Optimal Level of Advertising, con’t n Note: critics often argue that advertising makes consumers more brand loyal, i.e. makes demand inelastic. n This derivation shows that the causation could be the other way around: Because demand is price inelastic, more advertising is optimal.

26. Elasticity of Demand with respect to Advertising n “Shopping” goods: Relatively expensive and infrequently purchased, so you shop around for them. u Cars, computers, furniture. u Advertising relatively unimportant, you gather a lot of data on your own. n “Convenience” goods: Relatively inexpensive and frequently purchased. u Shampoo, soda, beer. u Advertising relatively effective.

27. Elasticity of Demand w.r.t. Advertising, con’t n Add in Nelson’s categorization of “Search” vs. “Experience” goods. u Search: Quality can be identified before purchase. Consumers search for the best total package of price and quantity. u Experience: Quality can only be determined after consumption. Consumers try different goods to determine whether or not to continue to use.

28. Elasticity of Demand w.r.t. Advertising, con’t

29. Dorfman-Steiner in Action

30. Advertising and Signaling n For experience goods, advertising can also be used to signal quality. n 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. u Price is can also be used as a signal of high quality.

31. Free Rider Problem in Advertising n Advertising can have positive externalities for other firms in an industry. n With positive externalities, there will be too little advertising due to free-riders. n Thus we might suspect that in industries with large numbers of firms (and thus large positive externalities) advertising levels would be relatively low. u Supported by about 1/2 of studies.

32. Free Rider Problem con’t n One solution is group or cooperative advertising. u Got Milk? Campaign. u Plastics council. u McDonald’s.