Download Myths and Truths about Advertising

Lecture 7
Advertising Taxonomy
AEM 4550: ECONOMICS OF ADVERTISING
Prof. Jura Liaukonyte
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Lecture Plan
 Persuaders
 Informative view
 Model and Examples
 Signaling as Information
 “Memory Jamming” view
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PBS PERSUADERS: discussion
 http://www.pbs.org/wgbh/pages/frontline/shows/persuaders/
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Informative Advertising
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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.
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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.
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Model of Advertising as Information
$
Demand with
high advertising
Profit
Demand with low
advertising
MC
Quantity
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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.
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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
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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
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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
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Comparison
Persuasive/Complementary Model
 Higher advertising leads to
higher WTP and higher demand
for each consumer, which leads
to higher prices.
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Informative Model
 Higher levels of advertising leads
to more consumers but not a
higher demand for each
consumer, so prices do not
increase as a result of
advertising
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.
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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.
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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.
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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 quality/good deal.
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Signaling as Information
2.
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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.
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Signaling as Information
3.
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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
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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
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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
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Memory Jamming View of Advertisement
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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.
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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.
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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.
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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
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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
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Example: Breakfast Cereal Industry
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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
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Example: Soft Drink Industry
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Memory 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
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Supply Side 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
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Prisoner's Dilemma
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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.
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Cigarette Advertising on TV
1964
 All US tobacco companies advertised
heavily on TV
 Surgeon General issues official warning
 Cigarette smoking may be hazardous
 Cigarette companies fear lawsuits
1970
 Government may recover healthcare costs
 Companies strike agreement
 Carry the warning label and cease TV advertising in
exchange for immunity from federal lawsuits.
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