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PART III
PRICE AND NON-PRICE STRATEGIES
III.4
ADVERTISING
Examples
Pharmaceutical sector
- Similar expenses in marketing activities and in R&D
- Necessary marketing expenses? Wasteful?
Soft drinks
- Price competition plays a secondary role wrt advertising competition
In this chapter
- Advertising is considered with a strategic perspective
III.4.1 INFORMATION, PERSUASION, SIGNALING
To analyze the possible effects of advertising, classify goods in 3 categories:
- Search goods (PC)
- Experience goods (restaurants)
- Credence goods (medical services)
Classify advertising activities:
- Informative advertising (information about characteristics)
- Persuasive advertising (to influence consumers’ preferences)
Links:
- Informative advertising mainly associated with search goods
- Empirical evidence: advertising/sales ratio is 3x higher for experience goods than
it is for search goods
Social value of advertising?
- Is informative advertising the only one with social value?
- Look for efficiency arguments
Signaling
- Persuasive advertising can be considered as an indirect informative advertising for
some experience goods
- Example: Ford, Diet Coke at launch
- At launch, we have very little information
- We only know that advertising is expensive
Signaling
- Advertising expenditure can signal quality
- Ingredients:
! dynamic perspective (does not work for one-period goods)
! Experience goods (no information about the quality, the characteristics)
- Signaling theory:
! Averse selection
! Market failure
! Signaling
! Credibility, interpretation of signals
! Signals expensive enough, not too much
III.4.2 ADVERTISING INTENSITY
- To measure advertising intensity, compute a/R, where a are the advertising
expenses and R is the revenue from sales.
- Examples:
! In the salt industry, a/R is of the order of 0% to 0.5%
! For breakfast cereals, it is between 8% and 13% (Sutton’s estimates)
- How do we explain such differences?
Factor 1: Demand elasticity w.r.t. advertising
- Consider the following demand: D(a, p)
- Define demand elasticity w.r.t. advertising as
∂D(a, p) a
η=
∂a D(a, p)
- Some markets are more sentitive/reactive to variations in advertising than others.
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p p q Low η q High η Factor 2: Demand elasticity w.r.t. price
- Consider the following demand: D(a, p)
- Define demand elasticity w.r.t. price as
∂D(a, p) p
ε=
∂p D(a, p)
- Some markets are more sentitive/reactive to variations in prices than others.
- Advertising is €
more effective in markets with a low price elasticity of demand
because prices are generally higher in such markets.
Also, ads can decrease the price elasticity of demand p p q Low ε q High ε Formally
A monopoly:
Max Π = ( p − c)D( p, a) − a
p, a
€
FOC w.r.t. p implies the inverse elasticity rule
FOC w.r.t. a implies
€
€
p−c 1
=
p
ε
a p−c
=
η
R
p
Combining both FOC, we obtain the Dorfman-Steiner formula:
a η
=
R ε
- Advertising intensity increases with η and decreases with ε.
€
- Empirical support
Factor 3: Market structure
Higher advertising intensity in concentrated markets or in more competitive
markets?
How do ε and η vary with the number of firms, n?
- ε increases with the number of firms, n
! By decreasing its price, a firm not only increases total demand, but also
its market share.
! The second effect is greater for smaller firms.
! Therefore, price elasticity of demand is higher in markets with many
small firms.
! Advertising intensity is therefore lower in markets with many firms.
- How does η vary with the number of firms, n?
2 extreme cases
1. If advertising increase the demand for all firms equally
! Examples: milk, diamonds
! Advertising = public good
! The higher n, the more we share the benefits from advertising
! η decreases with the number of firms, n
! Less incentives to invest in advertising when n is high
! Example: Diamonds (distribution by DeBeers vs Russian producers)
2. The total demand is given, only market shares vary (Hotelling)
! Examples: pharmaceuticals
! Effect of ads: consumers switch from brand-name drugs to generics
! In a monopoly, η = 0
! In a duopoly, η > 0
! In a concentrated market, η increases with the number of firms, n
! More incentives to invest in advertising when n increases
To sum up, as n increases, we have 3 effects:
- markets shares are lower, ε is higher, a/R decrease
- Each firm captures a smaller share of the positive effect of advertising
- Hotelling
" The total effect is ambiguous.
Empirically:
- For high initial n, advertising intensity decreases with n
- For low initial n, advertising intensity increases with n
III.4.3 PRICE COMPETITION AND ADVERTISING
Interactions between the advertising strategies of competing firms.
- Prisonners dilemma for advertising expenses (as for price setting)
- If total demand is constant (Hotelling), each firm engages in advertising until
profits are zero
- Idem Bertrand competition
- This result on advertising can be nuanced in the same way as the Bertrand results
- Example: repeated interactions can decrease such wasteful advertising activities.
Collusion and advertising strategies
- Different timing between advertising strategies and price strategies:
! Decisions: frequent for prices, less frequent for advertising
! Effects: short-term for prices, long-term for advertising
! Time-discount factor likely to be lower for advertising activities
! A collusive agreement on advertising activities is more difficult to sustain
than one on prices
Interaction between price competition and advertising competition
- Advertising can soften price competition
! Generally, persuasive advertising increases product differentiation
! Therefore, it softens price competition
! Not only is advertising wasteful, but it is also anti-competitive
! But, how do we compare total surplus with and without advertising if
consumer preferences vary?
! Moreover, advertising increases the exchanged quantities, which argues
in favor of advertising, even persuasive
- Advertising can intensify price competition
! Informative advertising on prices decreases search costs
! Therefore, price competition intensifies
! But then, why would firm invest in such informative advertising?
! Prisonners dilemma again?