Download Economics of Management Strategy BEE3027

Economics of Management Strategy
BEE3027
Lecture 3
15/02/2008
Recap
• Last week we looked at:
– Property-rights motivation for existence of firms;
– Team production;
– Compensation schemes;
– Coordination problem in production.
This week
• We will look at:
• Strategic interaction in oligopolies:
– The role of managers and strategic delegation.
• Advertising.
Advertising
• Advertising is an integral part of our lives.
• It is also one of the largest industries:
– Global spending on advertising in 2005: $400bn
• Economists see advertising as a means to transmit
information about a good or service.
• However, there are 2 key aspects to it:
– Information receivers don’t pay for information;
– Information is transmitted by the seller.
Advertising
• Advertising expenditure is usually measured as
the ratio of adv expenditure to sales.
• This ratio varies drastically across industries:
• We will look at advertising from two different
perspectives:
– Persuasive advertising;
– Informative advertising.
Persuasive Advertising
• Models of persuasive advertising assume that
advertising enhances consumer preferences for
a given product.
• Hence, higher expenditures on advertising
result in increased demand for a product.
• Typically you’d think of the effect of advertising
as a rightward shift in the demand curve.
Persuasive Advertising
Persuasive Advertising
• Firm must balance out the effects on demand of a shift
in demand due to advertising expenditures and the
impact of a change in price.
• The balance is found when
 Q,A
A

PQ
 Q ,P
• Markets sensitive to advertising will have higher
advertising-to-sales ratios
Informative advertising
• In the real world, there are a number of different
products which cater to our needs.
• However, it is difficult to know all the products out
there and make an informed choice.
• Advertising can be seen as a means to inform
consumers of the existence of a product.
• In this sense, it may be socially productive to engage
in advertising activities.
Informative advertising
• Consider the case of a single consumer, in a
market with a single good.
– The price of this good is fixed at p.
– The benefit the consumer gains from the good is m.
• Hence, the consumer’s utility function is:
m – p if he purchases the good;
0 otherwise
Informative advertising
• There are two firms selling this product.
– There are zero production costs
• Firms can only use advertising as a tool to
boost sales.
– Advertising has a cost equal to A
• Therefore, the consumer may receive a total of
0, 1 or 2 ads from the two companies.
Informative advertising
• If the consumer receives no ads, he will not buy
the product.
• If the consumer only receives on ad, he will buy
the product from that company.
• If the consumer receives both ads, he will pay
p/2 to both firms.
– This is equivalent to flipping a coin to determine
which firm to buy the product from.
Informative advertising
• Therefore, the payoff to firm i is:
p – A if only firm i’s ad is received;
p/2 – A if both firms’ ads are received;
– A if firm i sends an ad but consumer does not
receive it;
0 if firm i does not advertise
• The fact that firms create ads does not imply
consumers will see them.
Informative advertising
• The probability that the consumer will see the
ad is the same for both firms and is equal to δ,
where 0 < δ < 1.
• So, the expected profit for firm i is:
δ(1- δ)(p-A) + δ²(p/2-A) – (1- δ)A if 2 firms advertise;
δ(p-A) – (1-δ)A if only firm i advertises;
0 if firm i does not advertise.
Informative advertising
• What is the social optimal level of advertising?
– The social planner wants to maximise consumer
surplus and total profit
• Expected welfare is:
δ(2- δ )m – 2A if two firms advertise;
Δm – A if one firm advertises;
0 if no firm advertises
Informative advertising
• Suppose that p would be set to its maximum
level, such that consumer surplus is zero
– i.e. p = m
– This way, welfare = profits and our analysis is made
much simpler!
• It is therefore socially optimal for two firms to
advertise if:
δ(2- δ )p – 2A > δp – A  p/A > 1/[δ(1- δ)]
Informative advertising
• So, there are combinations of p/A and δ in
which:
– It is profitable for each firm to advertise;
– But where it is socially inefficient to do so.
Informative or persuasive?
• So far, we’ve covered two different approaches to
advertising.
• These models assume that either:
– Consumers are aware of the product, but need “convincing”; or
– Consumers are unaware of the product, but would buy it once
they know about it.
• In reality, some consumers will not be informed, while
others will.
• In the latter case, it is likely some consumers will prefer
one product over others.
Targeted advertising
• The bottom line is that firms will be unable to
successfully reach the entire set of consumers.
• Firms must instead target a subset of
consumers for which their advertising appeals.
– It is almost impossible to identify product attributes
which are universally appealing;
– Advertising is costly, hence there will diminishing
returns to scale;
– Having a differentiated product gives firms market
power, thus implicitly segmenting their demand.
Targeted advertising
• Consider 2 firms, 1 and 2 producing
differentiated brands of the same product,
brand 1 and brand 2.
• There are two types of buyers:
– N inexperienced consumers;
– E experienced consumers.
• E is divided into:
– θ consumers who prefer brand 1;
– (1-θ) consumers who prefer brand 2.
Targeted advertising
• In this model, a firm may either use:
– Persuasive advertising, P, or
– Informative advertising, I.
• P only affects inexperienced consumers. So if
firm 1 chooses P:
– If firm 2 chooses I, firm 1 gets N consumers;
– If firm 1 also chooses P, both firms get N/2
consumers.
• I only affects experienced consumers.
– If firm 1 chooses I, it gets θE consumers;
– If firm 2 chooses I, it gets (1- θ)E consumers.
Targeted advertising
Firm 2
P
I
P
N/2, N/2
N, (1- θ)E
I
θE, N
θE, (1- θ)E
Firm 1
Targeted advertising
• Any of the 4 outcomes can be an equilibrium of this game
depending on certain market conditions.
• (P,P) is an equilibrium (i.e. firms only target inexperienced
consumers) if:
– N > E;
–
N
N
1
 
2E
2E
• (I,I) is an equilibrium (i.e. firms only target inexperienced
consumers) if
– E > 2N;
–
N
N
   1
E
E
Targeted Advertising
• If brand 1 is unpopular among experienced users, firm
1 will use persuasive advertising and firm 2 will use
informative advertising.
• (P,I) is an equilibrium if:
–
N
N
  min { ,1 
}
E
2E
Targeted Advertising
• If brand 1 is sufficiently popular among experienced
users, firm 1 will use informative advertising and firm 2
will use persuasive advertising.
• (I,P) is an equilibrium if
–
  max {
N
N
,1  }
2E
E