1. LECTURE 3: ADVERTISING ELASTICIES
AEM 4550: Economics of Advertising Prof. Jura Liaukonyte

2. Plan of the Lecture Economics of Superbowl advertising
Other Elasticities
Advertising Elasticity
Measures of Market Concentration
Relationship between Advertising and Market structure:
Dorfman-Steiner Condition
Optimal Advertising levels
Advertising to sales ratios across different industries
Product differentiation and Advertising

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4. Super Bowl Ads
The 21 most-watched television programs in American history are all Super Bowls
Super Bowl 2015 delivered its highest overnight TV rating ever
111.5MM viewers in 2014
114.5MM viewers in 2015
Cost of exposure in 2015, $4.5 million for a 30-second spot
Average CPM on TV for 2015 = $37.35.
CPM – Cost per Mille -  price an advertiser pays to reach a thousand viewers
Calculate CPM for a 2015 Superbowl ad = 4.5*1000/114.5 = $39.3

8. Price Elasticity of Supply
Measures the sensitivity of quantity supplied given a change in price
Measures the percentage change in quantity supplied resulting from a 1 percent change in price 84

9. Income Elasticity of Demand
Definition
Formula
Measures how much quantity demanded changes with a change in income
Sign indicates normal or inferior
 EI>0 implies normal good.
EI<0 implies inferior good.
Normal goods may be necessity or luxury. 79

10. Cross Price Elasticity
Definition
Formula
Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good
Complements: Cars and Tires
Cross-price elasticity of demand is negative
Price of cars increases, quantity demanded of tires decreases
Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
Price of butter increases, quantity of margarine demanded increases 79

11. Assume Psubst Increases
Size of shift in Demand
Assume Psubst Increases
EXY>1
EXY<1
Price
Price D’ D D D’
Demand for Product
Demand for Product

12. Example: The Cross-Price Elasticity of Demand for Cars
Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995),

13. Advertising Elasticity
Measures the sensitivity of demand given a change in advertising 84

14. Advertising Elasticity
Ad-inelastic demand curve: Demand does not shift much from advertising.
Example:
concrete: Consumers’ purchasing decisions are mostly based on price and related terms of sale.
Ad-elastic demand curve: Demand is relatively responsive to advertising.
soda: Consumers’ purchasing decisions can be easily swayed by effective advertising campaigns.

15. Advertising Elasticity
Two key results from advertising
The marginal gain from advertising expenditures is greater the more sensitive the demand curve is to advertising expenditures.
Firms should advertise more when the demand curve is more sensitive to advertising expenditures.

16. Lerner Index L = (p - MC)/p = 1/|EP| Lerner Index:
The higher the number, the more pricing power the firm has.
Mark-up power reflects monopoly power.
PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark-up will increase.

17. What are Sources of Monopoly Power?
Low elasticity of demand
We just showed this using Lerner Index.
Possibly due to strong product differentiation.
High barriers to entry
e.g., ownership of necessary raw materials, patents and regulatory barriers, scale economies, product diff.
Number of other competitors in market.
Interactions between firms: Compete or cooperate?

18. Product Differentiation
Products are different if there is some objective characteristic or property, real or perceived, that provides a basis for buyers to choose one over the other.
Product differentiation may lead to reduced own -price elasticity. As the degree of differentiation increases, the price elasticity will decrease.

19. Product Differentiation, cont.
Ways in which products are differentiated.
Product Brand
Packaging
Conditions of Sale
Service Provided
Location
Product Differentiation as an Entry Strategy
Product differentiation to create a niche market.
Product differentiation to deter entry.

20. Advertising and Monopoly Power
Assume a firm faces a downward-sloping demand inverse curve but one that shifts depending on the amount of advertising A that the firm does
P=P(Q, A)
Recall, the Lerner Index, LI
L = (p - MC)/p = 1/|EP|
Where |EP| is the price elasticity of demand

21. Advertising and Monopoly Power
Recall, the elasticity of output demand with respect to advertising A
Advertising/sales ratio =
Dorfman-Steiner Condition
For a profit-maximizing monopolist, the advertising-to-sales ratio is equal to the ratio of the elasticity of demand with respect to advertising relative to the elasticity of demand with respect to price.

22. Dorfman-Steiner
The Dorfman-Steiner formula relates the sales ratio to price- cost margin and elasticity.
The advertising-to-sales ratio is greater the greater the advertising elasticity of demand and lower the price elasticity of demand (or the greater the price-cost margin).

23. Intuition Behind D-S
Recall: the greater the demand elasticity, the lower the optimal price.
Price-cost margin is smaller when elasticity is higher.
Since the price-cost margin is smaller with elastic demand, the gain from advertising is also smaller even if the increase in quantity demanded is the same.
The marginal gain from advertising is greater the greater the price-cost margin.

24. Example
Suppose you have been hired to marker a new music recording that is expected to have target sales of $20 million for upcoming year
The marketing department has estimated that 1% increase in advertising will translate to 0.5% increase in sales
And that 1% increase in the price of the recording would reduce the number sold by about 2%
How much money should you commit to advertising the recording in the coming year?
Scenario
Question

25. Advertising to Sales Ratios
This ratio varies between industries
Salt industry: a-s-r = 0 to .5%
Breakfast cereals industry: a-s-r= 8% to 13%
Advertising intensity depends on:
The type of product
Advertising elasticity of demand
Price elasticity of demand

26. Highest Ad-to-Sales Ratios (2010 data)

27. Lowest Ad-to-Sales Ratios

28. Profit Maximization: MR=MC
Set Up
profit(q) = TR(q) – TC(q)
Optimization
How to maximize profit?

29. Profit Maximization: MR=MC
Set Up
profit(q) = TR(q) – TC(q)
Optimization
Profit maximization: dprofit/dq = 0
This implies dTR(q)/dq - dTC(q)/dq = 0
But dTR(q)/dq = marginal revenue
dTC(q)/dq = marginal cost
So profit maximization implies MR = MC

30. Profit Maximization: Monopoly Condition
Derivation of the monopolist’s marginal revenue
$/unit
1. Demand: P = A – B*Q
2. Total Revenue: TR = P*Q = A*Q – B*Q2
3. Marginal Revenue: MR = dTR/dQ
4. MR= A-2B*Q A
Demand
With linear demand the marginal revenue curve is also linear with the same price intercept …
but twice the slope
Quantity MR

31. Market Concentration Numbers and size distributions of firms
Different Market Structures
Numbers and size distributions of firms
Ready-to-eat breakfast cereals: high concentration
Newspapers: low concentration
Measurements of market structures
Concentration ratio,
Herfindahl-Hirschman Index (HHI)
Lerner Index (LI)

32. Industry Concentration
Four-Firm Concentration Ratio
The sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales
Herfindahl-Hirschman Index (HHI)
The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000  S wi2, where wi = Si/ST.

33. Measure of concentration
Firm Rank
Market Share
(%)
Squared Market Share
625
625
625 25 25 25 25 25
Concentration Index

34. Measure of concentration
Firm Rank
Market Share
(%)
Squared Market Share 1 25
625 2 3 4 5 6 7 8 Σ Σ
Concentration Index

35. Measure of concentration
Firm Rank
Market Share
(%)
Squared Market Share 1 25
625 2 3 4 5 6 7 8 Σ 10 Σ
100
Assume firms 4 and 5 merge
Concentration Index

36. Measure of concentration
Firm Rank
Market Share
(%)
Squared Market Share 1 25
625 2 3 4 5 6 7 8 Σ 10 Σ
100
The concentration indices change
Concentration Index
CR4 = 80 85
H = 2,000
2050

37. HHI
The Herfindahl-Hirschman Index – the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50)
Definition
Properties
In perfect competition, the HHI is small
In monopoly, the HHI is 10,000 (100 squared)
A popular measure with the Justice Dept in the 1980’s
HHI < 1000 characterized competitive markets
HHI > 1800 would bring Justice Dept challenge to proposed mergers
Example
E.g. The cigarette industry is highly concentrated with only 8 firms and a Herfindahl-Hirschman Index (HH1) of 2623

38. Example: Candy and Chocolate Industry

39. Candy v. Chocolate CANDY HHI (for top 4) = 1141 CR ₄ = 59%
Medium level concentration
->Concentration is increasing!
1,039 businesses overall!!
CHOCOLATE
HHI (for top 4)=
Cr ₄ = 78.1%
High level of concentration
518 Businesses overall!!

40. CR₄ and HHI: Candy Industry
The HHI for just the top 4 companies in the industry is
The CR ₄ for the industry is 78.1%.
Therefore, the industry is highly concentrated with only a few major firms holding a majority of the market share.
CR ₄ = = 78.1%
*Hershey and Mars Inc. alone hold 71.1% of the market share.
-Note that students calculated HHI incorrectly (need to add squared market shares for top 50 companies, not only top 4)

41. Example: Credit Card Industry

42. Market Definition All Credit Lending Institutions with their own card
27.2% J.P. Morgan Chase & Co.
19.2% Bank of America Corporation
18.9% Citigroup Inc.
17.2% American Express Company
4.0% Capital One
CR4: 83.2
HHI:
Total Number of Companies: 192

43. What is a Market? No clear consensus
the market for automobiles
should we include light trucks; pick-ups SUVs?
the market for soft drinks
what are the competitors for Coca Cola and Pepsi?
With whom do McDonalds and Burger King compete?
Presumably define a market by closeness in substitutability of the commodities involved
how close is close?
how homogeneous do commodities have to be?

44. Fast-Food Outlets
Burger King
McDonald’s
Wendy’s