Chapter 13 - Advertising

A number of interesting questions we can ask concerning advertising:

1. How do economists view advertising? Is it considered to increase efficiency or a waste of resources? There is not an agreement on this question.

In order to answer the first question, we need to know more about:

2. Why firms advertise?

3. What the impact of advertising is?

Economists have often viewed some advertising as efficient, because it is considered a way to increase information to consumers. But advertising can also be viewed as inefficient and a waste of money.

So why do firms advertise?

informative purposes

persuasive purposes

(or another way to think of this is to differentiate their product (whether it is different or not...)

Why do firms want to differentiate their product? To make their demand curve more inelastic, which means both 1. more ability to raise price and 2. higher quantity. Both can raise revenues.

If a company is selling a 'search' good, one whose characteristics can be ascertained before purchase, then they will primarily use informative advertising. If a company is selling an 'experience' good, it may rely more on persuasive advertising.

(I'm not too crazy about the book's example, since they identify computers as search goods and wine as experience goods, but what about the fact that computers may crash? So the process of differentiating search from experience goods is not as easy as one might think.

Is most advertising for informative or persuasive purposes? Given that 3 times as much is spent on advertising experience goods than search goods, it seems the latter.

How would one approach this question empirically?

1. First the researcher needs a definition of informative versus persuasive advertising.

The assumption here is that informative=search and persuasive=experience.

2. In that case we need to have a way of differentiating search and experience goods.

3. Finally we need a measure of advertising. The measure used in this case is advertising/sales (or revenues - a/R).

But another question is: is high advertising expenditure a signal of quality?

Again this would suggest that advertising is efficient, because it allows firms to signal quality.

Advertising has also become more complex, as customers have become more savvy.

Some ads actually play off of consumers cynicism.

Think about some ad campaigns you are familiar with - are they done for informative or persuasive purposes?

How can we show economically the impact of advertising?

1. Advertising is more effective when demand is inelastic.

2. Advertising is more effective when demand is ad-elastic.

The book shows in Figure 1 that it is preferable for firms with ad-elastic demand to advertise. Ad-elastic means sensitive or responsive to advertising.

Can provide a formula for the THEORETICAL relationship between advertising and elasticity called the Dorfman-Steiner formula:

a/R = [(p-MC)/p]h = e/h

where e is the price elasticity of demand and h is the demand elasticity wrt advertising expenditures or dQ/da

How are advertising and market structure linked?

This theory suggests we should observe more advertising in more concentrated markets (since more market concentration means more inelastic wrt to price.)

What about h?

In the case of undifferentiated products, advertising becomes public good or another way of thinking about it is that other firms gain a positive externality when one firm advertises. It also means that individual firms cannot capture all of the benefits of the advertising and thus it is more costly for them.

Ex: deBeers, Almonds, Milk

(Interestingly, in each case there has been a generic ad campaign (paid in the latter two cases by a consortium of farmers/dairies), but individual firms are also trying to capture demand through name brand recognition. (Known as spurious product differentiation.) If most advertising is spurious then advertising is inefficient.

Notice that often the impact of such ad campaigns is to shift the whole demand curve for the product outwards.

On the other hand, most advertising is intent on getting consumers to switch (ie increase market share) rather than increasing overall demand, which in turn leads to more advertising, by firms trying to maintain market share. Here again we see the emergence of game theory. The impact of advertising is NOT to increase revenues for the industry as a whole, but only to shift market share. But if you advertise, you might capture more market share. And if you know your rival will advertise, you have to counter by advertising, or risk losing market share. So the best solution is a prisoner's dilemma.

When is advertising effective in capturing additional market share? Certainly not in the case of a monopolist, who already has all of the market.

Advertising strategies may also vary.

Advertising product characteristics is different from advertising price.

The former may be associated with lessened price competition, while the latter may be associated with increased price competition.