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Chapter 10:
Advertising
Industrial Organization: Contemporary Theory & Practice
Introduction
• The emergence of advertising is closely connected with the
emergence of mass media
• The result has been a tremendous revolution in the shopping
experience
• Because of widespread advertising, modern consumers enter a
store with a wealth of information about alternative products,
styles, qualities, and prices
• This has changed the ways that firms market products
• In turn, the development of sophisticated advertising has altered
– structure of markets
– nature of firms
Industrial Organization: Contemporary Theory & Practice
Impact of Advertising
• Without advertising
– lack of information about products
– shopping is generally local and based upon visual
comparison
– firms can operate on a small scale as each competes for
a small local market
• With advertising
– comparison shopping is considerably eased as
consumers have better information about range of good
on offer
– firms have an incentive to widen the range of goods
they offer and to operate on a larger scale
Industrial Organization: Contemporary Theory & Practice
Some Important Questions
• If advertising affects consumer buying behavior, how?
– Does advertising alter consumer tastes?
• If so, how?
• And is this bad or good?
– Or does advertising just provide consumers with more
information
• In either case, does advertising promote efficiency or is it
socially wasteful?
• Does advertising create new markets? Or does it merely
exploit existing markets?
• Does advertising increase demand in general? Or does it
increase demand for particular branded goods?
• None of these questions admit of easy answers!
Industrial Organization: Contemporary Theory & Practice
Some Conceptual Issues
• Distinguish national and local advertising
• Local
– low quality and cost
– primarily informative: availability, price, associated
services
• National
– higher quality and cost
– much less informative
• little mention of price
– intended to create an image associated with a brand or
firm
Industrial Organization: Contemporary Theory & Practice
Starting Points
•
•
•
•
Advertising is a free service to consumers
But it is costly to produce
Must, therefore, generate a benefit for the firms involved
There is evidence that such benefits exist
– high advertising expenditures by industry associated
with high levels of profitability
• High: cereals, perfumes, soap, pharmaceuticals
• Low: hats, carpets, jewelry
• This advertising/profitability relationship has been
relatively stable over time
• Moreover, it also tends to be the same industries over time
that are characterized by both high advertising intensity
and high profits
Industrial Organization: Contemporary Theory & Practice
Starting Points (cont.)
• This evidence though does not tell us the direction of causation
– does advertising increase profit?
– or does profits lead to advertising?
• Besides causation, other issues arise, too
– Advertising may permit new firms/products with lower costs
to compete with established goods by increasing consumer
information
• Advertising may still raise profits
• But in this scenario, advertising raises competition and so
is beneficial
– However, advertising may enhance existing brands and
reduce competition
• advertising then is wasteful
• especially if it intensifies product differentiation
Industrial Organization: Contemporary Theory & Practice
Preliminary: Truth in Advertising
• Much popular discussion is concerned with the possibility of
fraudulent advertising, e.g. the “snake oil” sellers of the Old West
• For advertising to be illegal it must contain claims that are
– demonstrably false
– affect a significant number of consumers
• These criteria are often difficult to meet—especially for consumers.
But rivals to illegally promoted goods may help
– AstraZeneca makes the drug Nolvadex (generically Tamoxifen)
– As of 1999, was the only drug approved for use to prevent breast
cancer in women at high risk for the disease
– Eli Lilly’s drug, Evista (generically known as Raloxifene) has been
approved for treating breast cancer but not preventing it
– Lilly advertised Evista to doctors as a preventitive and doctors
began to prescribe it.
• AstraZeneca sued and won a court order that Lilly stop its promotion
Industrial Organization: Contemporary Theory & Practice
Truth in advertising (cont.)
• This case outlines the general approach of FTC in cases where
fraudulent advertising is found to have taken place
– issue a “cease and desist” order
– on rare occasions insist on a counter-ad being issued
• Of course, there are a number of other instances of dishonest
or fraudulent advertising. A review of these cases implies that
fraudulent advertising most likely
– when purchase is necessary to test the claims, e.g., “eating
this product will make one lose weight”
– when claiming compensation is far from easy
– Consumer is not in a position to evaluate the claim
– Consumer cannot obtain recourse if claim is found to be
false because the firm is a “fly-by-night” type
Industrial Organization: Contemporary Theory & Practice
Early Economic Analysis
• As note at the outset, advertising expenditure is considerable and may
account for over 2% of US GDP
• Besides the possibility of dishonesty, early economic analysis focused
on two other effects of advertising
– change in consumer preferences
– creation of monopoly power
• Some evidence that advertising may raise market power comes from
comparing national brands with generics
– heavily advertised national brands always sell for a premium even
though chemically or structurally identical
– the obvious inference is that advertising somehow creates a real or
imagined perception that the national brand is superior
• But is this inefficient?
• Is it even inaccurate?
Industrial Organization: Contemporary Theory & Practice
Early Economic Analysis (cont.)
• However, the idea that advertising is harmful if it changes tastes
needs to be carefully considered
– Suppose that the demand curve without advertising is
P = 100 – Q, and marginal cost is c = 20. It is easy to show
that the monopolist price is $60 at which the monopolist sells
40 units. Consumer surplus is $800.
– Suppose advertising raises everyone’s willingness to pay by
$50 so that the demand curve with advertising is: P = 150 - Q
• The new profit maximizing price and output are: P = $85
and Q = 65.
• Consumer surplus is now $4227. Advertising has affected
consumer tastes but this does not mean consumers are
worse off. Consumer surplus has increased.
Industrial Organization: Contemporary Theory & Practice
Early Economic Analysis (cont.)
• The foregoing analysis is simple and the results can be
altered. Still, it makes the point that caution is needed in
evaluating the economic effects of advertising
• One way to reverse the above finding is to introduce some
competition
– suppose all manufacturers reason that advertising will
raise profit and therefore all increase advertising
– we might then get excessive (wasteful) advertising
• ZIP Airlines and Gamma Airlines compete through
advertising expenditures SZ and SG
– profit for ZIP is (60 - SG)SZ - SZ2
– profit for Gamma is (60 - SZ)SG - SG2
– SZ and SG can take the values 10, 15 or 20
– how much will each firm spend?
Industrial Organization: Contemporary Theory & Practice
Wasteful Advertising Rivalry
2
leads
pCompetition
=
(60
S
)S
S
Z
G Z
Z
both firms to choose too
high a level of
advertising
10
ZIP (SZ)
10
(400, 400)
pG = (60 - SZ)SG - SG2
Gamma (SG)
15
20
This is the
(350, 525)
(300, 600)
Nash
equilibrium
15
(525, 350)
(450, 450)
(375, 500)
20
(600, 300)
(500, 375)
(400,
(400, 400)
400)
Industrial Organization: Contemporary Theory & Practice
Advertising: What is the Message?
• As we have just seen, the early analysis argued that
– Advertising can affect consumer tastes—But this may not be
bad
– Advertising can be wasteful—But the main losers appear to be
the oligopolist firms who depress each other’s profits with
excessive advertising
• But early work also revealed that advertising can be procompetitive by increasing consumer information
• Benham’s (1972) classic study showed eyeglasses were cheaper in
states where advertising of prices was legal
• At the same time, many note that a lot of advertising, especially
national brand advertising, does not even mention price or even the
function of the product.
• Two related questions follow:
– What is the role of such contentless advertising?
– Can it be procompetitive?
Industrial Organization: Contemporary Theory & Practice
Advertising as Signaling
• Nelson (1970, 1974) was among the first to offer a formal answer to
the two questions just raised. He argued that:
– Advertising would be informative even when it did not mention
price or function or other key features; and
– This informative role would be positive for consumers
• Nelson distinguished between two types of goods
– search goods, e.g., foodstuffs, sweaters
• Here the primary issue is where the goods are available, and
what price they sell at
• For search goods, advertising provided information much the
way suggested by Benham’s eyeglass study and so played a
positive role
– experience goods, e.g., electrical goods, computers, wine,
restaurant meals
• Here the issue is the quality of the good and that can be
assessed only after purchase and experience:
Industrial Organization: Contemporary Theory & Practice
Advertising as signaling (cont.)
• For experience goods advertising could be a signal of high quality
even when it otherwise seems without content
– producer is better informed of true quality than buyer
– makers of high quality goods want to inform consumers
• they want repeat purchases
• if the producer of a high quality good can get the consumer to
try it just once, he knows that the consumer will continue to
buy
• Producers of a low quality good will not earn repeat
purchases—dissatisfied consumer will not come back
• Nelson argued that this leads to an equilibrium in which only
makers of high-quality goods will advertise. Why?
Industrial Organization: Contemporary Theory & Practice
Advertising as signaling (cont.)
• Nelson’s argument is based on the following logic
– Advertising in the current period incurs an immediate cost
– The return to this investment comes mainly from the extra future
sales it generates as consumers come back again and again
– For experience goods, whether consumers come make repeat
purchases depends on how the good worked the first time
– advertising could “fool” consumers into trying a product that the
manufacturer knows is low quality but the manufacturer also
knows that these consumers will not be back
• So a low quality good cannot earn the extra margin from
repeat purchases necessary to make advertising worthwhile
– Consumers will be back to buy a high quality good
• So a high quality good can earn the extra margin from repeat
purchases necessary to make advertising worthwhile
• So only high-quality goods exhibit high advertising levels
Industrial Organization: Contemporary Theory & Practice
Advertising as signaling (cont.)
• If Nelson’s argument is correct, then the very fact that a firm
advertises signals to consumers that the good is high quality.
However, Nelson’s argument has run into both theoretical and
empirical obstacles
– At the theoretical level, it has been noted that low quality goods
may be much cheaper to make. So, a firm that advertises a low
quality good may find it worthwhile because even the returns
from tricking consumers into trying it once may be substantial
– At the empirical level, there seems to be little correlation
between advertising and independent measures of quality
– In fact, Nelson’s argument suggests that firms may want to
publicize just how expensive their advertising is. But we rarely
if ever observe such behavior
Industrial Organization: Contemporary Theory & Practice
Advertising as a Complement
• Becker and Murphy (1993) have suggested that advertising is best
viewed as a complement to consumption, i.e., advertising raises
the value of the good consumed. This can happen in two ways
– Advertising can act like a network externality to create crowd
appeal
• Consumers like goods that other people know about
• The more a brand is advertised and known the more
consumers like it
• The more they like it, the more they buy it and this may
raise its value further
– Advertising can make a good more valuable by providing key
information that enables customers to use the product better
• For example, letting consumers know that membership in a
resort not only provides access to golf but also to tennis
courts may make tourists willing to pay more to stay there
Industrial Organization: Contemporary Theory & Practice
Advertising and Crowd Appeal
• Both the crowd appeal and the information views can explain why
consumer goods are more heavily advertised than producer goods and
why firms keep advertising the same good long after its introduction
A Simple Model of the Crowd Appeal View of Advertising
 N + 1 consumers of a particular good
 Different tastes described by preferences on interval [0, q*]
 Consumer 1 gets utility 0
 Consumer 2 gets utility q*/N …
 Consumer n gets utility (n - 1)q*/N
 Final consumer gets utility Nq*/N = q*
Industrial Organization: Contemporary Theory & Practice
Advertising and Crowd Appeal (cont.)
 Advertising affects utility for each consumer
 For each consumer advertising expenditure of S increases utility
by a multiple s(S): consumer n gets utility s(S) (n - 1)q*/N
 Assume that s(1) = 1 and that s(S) is increasing in S
 Each consumer buys exactly one unit of the good at price P
provided that there is consumer surplus from doing so
 So for consumer n to buy the good it must be the
case that: s(S) (n - 1)q*/N > P
 This identifies the marginal consumer nm =
Industrial Organization: Contemporary Theory & Practice
NP
s(S)q*
+1
consumers
Advertising and Crowd AppealAll(cont.)
above nm buy
 The minimum value of nm is 1 and the maximum value is N + 1
 The number of consumers is N + 1 - nm
= N - NP/ s(S)q*
 So demand at price P and advertising expenditure S is:
QD(P, S) = N(1 - P/ s(S)q*)
Suppose that advertising
expenditure is SL
 This gives demand DL

$
Demand with
high advertising
s(SH)q*
s(SL)q*
DH
DL
Demand with
low advertising
N
Increase advertising
expenditure to SH


Demand increases to DH
Quantity
Industrial Organization: Contemporary Theory & Practice
Advertising as Complementary Information
• The crowd appeal approach assumes that consumers enjoy
advertising
• So they will seek out advertising
• If “messages” are sent they will be received
• But what if this is not the case?
• Then there is a “hit or miss” aspect to advertising
• This suggests an alternative approach
– advertising informs but is not certain to be received
– consumers buy a good only if they see an advertisement
for it
– otherwise they are uninformed of the good’s existence
Industrial Organization: Contemporary Theory & Practice
Advertising as Information (cont.)
• To buy consumers must receive an advertisement
• But consumers do not buy more if they see more
advertisements
 Let individual demand be q(P) = a - bP and let there be N consumers
 Suppose that if one ad is issued the probability of each consumer
receiving it is 1/N
 Then if 2 ads are issued the probability of neither ad being seen by
anyone is (1 - 1/N)2
 And if S ads are issued the probability of no consumer seeing any of
them is (1 - 1/N)S.
 This can be approximated by e-S/N
Industrial Organization: Contemporary Theory & Practice
Advertising as Information (cont.)
 So if S ads are issued the number of consumers who see
at least one and so consider buying is (1 - e-S/N)N = g(S)
Different approaches to
 So demand at price P and advertising
intensity
S is
advertising
give different
impacts on demand
QD(P,S) = g(S)(a - bP)
Suppose that advertising
expenditure is SL

$
Demand with
high advertising
a/b
DL
Demand with
low advertising

This gives demand DL
Increase advertising
expenditure to SH


Demand increases to DH
DH
g(SL)a
g(SH)a Quantity
Industrial Organization: Contemporary Theory & Practice
Profit Maximizing Choice of Advertising
 Take the advertising as information approach:
Q(P,
g(S)(a - bP)
This
hasS)to= be
maximized with
respect to P and S
 Suppose that marginal production costs are c and that each ad costs t
to issue
 Then profit is p(P, S) = (P - c)Q(P,S) - tS
 For any demand curve we know that marginal revenue can be written
of demand
MR = P(1 - 1/hP) where hP is the price
Thiselasticity
relates the
pricecostmarginal
margincost
with the
 Condition 1 (on P): marginal revenue equals
price elasticity of
P*(1 - 1/hP) = c so P* - c = P*/hP
demand
P* - c
1
so
=
hP
P*
Industrial Organization: Contemporary Theory & Practice
Profit Maximizing Advertising (cont.)
 Now consider advertising expenditures
 The profit maximizing choice of S satisfies:
p(P, S)/  S = (P - c) Q/ S - t = 0
so
Q
(P - c) = t
S
but then
recall that
so
Q
S
Q
S
(P* - c)
t
=
P*
P*
P* - c
1
=
P*
hP
1
t
=
P*
hP
Industrial Organization: Contemporary Theory & Practice
Profit Maximizing Advertising (cont.)
 We have
Q
S
1
t
P*
=
hP
 Multiply both sides by S*/Q*
S*
Q*
Q
S
1
hP
=
 Consider the expression
tS*
P*Q*
S*
Q*
 So the left hand side becomes
This is an elasticity: the
elasticity of demand with respect
Q
to advertising expenditures
S
hS
hP
Industrial Organization: Contemporary Theory & Practice
Profit Maximizing Advertising (cont.)
 Now consider the expression
tS*
P*Q*
 The numerator is total advertising expenditure
 The denominator is sales revenue
 So we have the condition
Advertising Expenditure
=
Sales Revenue
hS
hP
Industrial Organization: Contemporary Theory & Practice
Advertising Spending
• This is the Dorfman-Steiner result
– consistent with a negative relationship between the elasticity of
demand and advertising
– implies that low advertising induces high advertising rather than
the other way round
– increase in advertising only affects share of revenue spent on
advertising if it affects demand elasticity: advertising-to-sales ratio
is constant if elasticities are constant
– more is spent on advertising if consumers react more to advertising
• response is likely to be greater for “convenience goods”
– consumers value easily available information
• than “shopping goods”
– consumers likely to shop around
– more spent on advertising experience than search goods
Industrial Organization: Contemporary Theory & Practice
Advertising and Competition
• Can we extend the Dorfman-Steiner result to markets in
which there is competition?
– suppose there are “many” very similar firms
• then there is likely to be a free-rider problem
– each firm tempted to free-ride on others’ marketing efforts
• so too little advertising
• leads to the need for collaborative marketing efforts: “Drink Milk”
– suppose that there are few firms selling differentiated products
• then expect stronger incentives to advertise
• may find a prisoners’ dilemma effect
• so there is a connection between advertising and industry
concentration
• but this is not a causal relationship
Industrial Organization: Contemporary Theory & Practice
Industrial Organization: Contemporary Theory & Practice