Mathematical Social Sciences 51 (2006) 153 161

www.elsevier.com/locate/econbase

Strategic advertising: The fat-cat effect and stability B

Hamid Beladi a, Reza Oladi b,*
a
b

Department of Economics, University of Texas at San Antonio, United States

Department of Economics, Utah State University, 3530 Old Main Hill, Logan,
Utah 84322-3530, United States

Received 1 September 2003; received in revised form 1 November 2004; accepted 1 August 2005
Available online 28 September 2005

Abstract
We use the theory of social situations (TOSS) to examine the stable advertising behavior and pricing. In
contrast to the current literature, we show that the incumbent firm need not maintain a hungry-look by
under-investing in advertising expenditure in order to deter entry.
D 2005 Elsevier B.V. All rights reserved.
Keywords: Advertising; Competition; Market structure; Theory of social situations
JEL classification: C7; D4; M0

1. Introduction
The effect of advertising on competition has been studied extensively in much of the
second half of the 20th century. The celebrated work of Bain (1956) considered the effect of
advertising expenditures on intensity of competition and concluded that such expenditures
have major anti-competitive consequences. Schmalensee (1974, 1983) studied the strategic
effect of advertising on barriers to entry. In a game theoretic framework, Schmalensee
(1983) formulated a model of advertising game along with post-entry quantity competition.
He concluded that an incumbents advertising investment encourages entry rather than
deterring it.

We would like to thank two anonymous referees and an associate editor for their helpful comments and suggestions. All
possible errors are ours.
*Corresponding author. Tel.: +1 435 797 8196; fax: +1 435 797 2701.
E-mail address: oladi@econ.usu.edu (R. Oladi).
0165-4896/$ - see front matter D 2005 Elsevier B.V. All rights reserved.
doi:10.1016/j.mathsocsci.2005.08.001

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H. Beladi, R. Oladi / Mathematical Social Sciences 51 (2006) 153161

Fudenberg and Tirole (1984), by setting a simple model of advertising and price competition,
confirmed the earlier results that heavy investment in advertising cannot deter entry. More
specifically, their main result states that the incumbent should under-invest in advertising in
order to deter entry, avoiding the bfat-catQ effect. That is, the incumbent must maintain a
bhungry-look.Q
In this paper, we use the theory of social situations (Greenberg, 1990) to investigate the
stability of advertising and price competition. Among other advantages of the theory of social
situations (TOSS, hereafter), the solution concept offered by TOSS assumes forward-looking
players. In comparison, the naive players of the Nash negotiation process assume the
commitment of the opponents to the current strategies when contemplating a move. That is,
Nash players are myopic. Instead, according to the stability approach offered by TOSS, when a
player considers a move, he takes into account further moves by rivals. In our context of
advertising and pricing, TOSS allows us to consider situations where management does not take
the advertising investment and price of the rival firm as given, as it is assumed in Nash
equilibrium.
According to the TOSS notion of stability, a price pair is stable if any beneficial price change
by any firm is necessarily unstable as it will result in another price change leading to another pair
of stable prices. This is in contrast to the underlying assumption of Nash, where any beneficial
price change is plausible regardless of the status of the resulting price pair. It is in this sense that
the players in our setup are forward-looking and not myopic.1 It is more plausible that the
managerial decisions made by firms on advertising expenditure are based on these stable
outcomes, which are most likely to be the end results.
We consider a game similar to Fudenberg and Tirole (1984) and show that the Pareto
optimum prices, soft post-entry competition, as well as fierce competition are stable. More
specifically, we show that in order to deter entry the incumbent need not maintain a bhungrylook.Q That is, the fat cat who seeks stability may not be doomed by the bfat-catQ effect. This
result is in sharp contrast to the current literature. Note that one may obtain similar results using
an infinitely repeated game framework. However, we believe that the use of TOSS is more
appealing as it does not involve the use of complex dynamic punishment strategies, commonly
used in infinitely repeated games.
The results of our model have important policy implications for managerial decision making.
Specifically, we demonstrate that the competitive pricing strategy and advertising, to a large
extent, depends on the nature of decisions made by firms, such as myopic and more insightful
orientations. The battle for market share between incumbent and entrant depends significantly on
the aggressive posture and persuasive advertising strategies of incumbent. Finally, our
framework provides a theoretical foundation for empirical studies on advertising expenditure
and its effect on competition.
The layout of the paper is as follows. In Section 2 we set up the model. This section heavily
depends on Fudenberg and Tirole (1984). We then analyze a price competition game with
advertising in Section 3. Finally, Section 4 provides the concluding remarks. Proofs of Section 3
are presented in Appendix.

Therefore, in some weak sense firms in our formulation have foresight. However, as one of the anonymous referees
pointed out, this does not embody full farsightedness, considered by Chwe (1994) and Xue (1998). It is certainly
interesting (but beyond the scope of this paper) to investigate the application of consistent sets, offered in Chwe (1994)
and Xue (1998), to the current problem.

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155

2. The model
Following Fudenberg and Tirole (1984), we assume a unit population of consumers who buy a
product if they are informed of it. There are two periods, 1 and 2. In period 1 an incumbent
monopolist supplies the product to informed consumers. In the second period, however, an entrant
may enter. Both firms advertise in newspapers and inform the consumers of both the existence of
their products and their prices. We assume, as in Fudenberg and Tirole (1984), that once a
consumer gets an badQ in the first period, he will not bother to read the ads in the second period.
Firm i, i = 1, 2, supplies the good i.2 Let firm 1 be the incumbent. The demand functions for
the two goods are given by,
D1 p1 ; p2

D2 p1 ; p2

where the consumers are aware of both products. When consumers are not aware of a good, e.g.
good 2, we denote the demand function by D 1( p 1, l). This indicates that firm 1 is a monopolist
in the (segment of the) market. However, we exclude the possibility of price discrimination.
Accordingly, the revenue (net of costs) that an informed consumer brings to the firms are:
R1 p1 ; p2

R2 p1 ; p2

4
B2 Ri
Bpi Bpj

where R i is twice differentiable, quasi-concave, and

N0; i; j 1; 2; ipj. The last
assumption states that the marginal revenue of firm i increases with firm js price. Note that,
following our formulation of the demand functions, if the consumer does not know of good j, the
revenue the consumer brings to the firm i will be R i ( p i , l).
Let the cost of reaching a a [0,1] portion of population be u(a), where u is assumed to be
convex and u(1) = l. In period 1, the incumbent advertises a by spending u(a) and in the
second period both firms spend a fixed amount u, allowing them to reach (1  a) portion of the
population jointly.The profit functions are as follows,
P1 aRm  ua daR1 p1 ; l 1  aR1 p1 ; P2  u 

P2 d1  aR2 p1 ; p2  u 

where R m is the monopolist revenue and d is the discount factor.3 The terms in the first brackets
in Eq. (5) is firm 1s profit in period 1, while the terms in the second brackets represent its profit
in period 2.
3. The advertising and price competition game
Assume that the firms engage in post-entry advertised price competition. A strategy for firm i,
i = 1, 2, is a price p i a X i = [0,l]. Let X = X 1  X 2 be the set of all strategies. The advertising and

2
3

We use subscript for firms (goods).

This set up along with assumptions are borrowed from Fudenberg and Tirole (1984).

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price competition game is the triple G = (N,X,{P i }iaN ), where N = {1, 2} is the set of players and
T i is the payoff function for player i, defined by Eqs. (5) and (6). Let w 1 and w 2 be the best
response functions for firm 1 and 2, respectively, that is, w1 p2 arg maxp1 aX1 P1 and
w2 p1 arg maxp2 a X 2 P2 .
We assume that the profit functions are symmetric around the best response functions, i.e., for
all p V, pW, pj a X such that p iV = w i ( p jV), p jV = p jW = p jj, p iW = p iV  e, p ij = p iV + e, e N 0, we have,
P i ( p W) = P i ( pj), i, j = 1, 2, i p j. In other words, profit functions are symmetric around the best
response if a price deviation above or below the best response price by the same amount leads to
the same loss in profit. This property is satisfied by linear demand functions.
The following lemma addresses the well-known result that prices are strategic complements.
That is, a firm responds with a higher price, the higher is its rivals price.
Lemma 1. w i is increasing in p j , i, j, = 1, 2, i p j.
Proof. See Fudenberg and Tirole (1984).

Definition 1. A pair of strategies (p 1 , p 2 ) is a Nash equilibrium if p 1 = w 1 (p 2 ) and p 2 = w 2 (p 1 ),

i.e., p 1 = w 1 (w 2 (p 1 )).
We assume, as in Fudenberg and Tirole (1984), that such an equilibrium exists. The following
lemma addresses the impact of advertising.
Lemma 2. An increase in a increases the best response price of firm 1.
Proof. See Fudenberg and Tirole (1984).

The above result states that the advertising expenditure increases firm 1s best response price,
for any given price of its rival.
Proposition 1. An increase in advertising a increases the Nash equilibrium prices.
Proof. See Fudenberg and Tirole (1984).

Lemma 2 and Proposition 1 are the essence of fat-cat effect. According to the Nash
equilibrium of the game, an increase in incumbents goodwill (its market captivity, obtained by
advertising expenditure) makes the incumbent unwilling to match the entrants price. In other
words, market captivity makes the incumbent a pacifist. Therefore, based on the Nash
equilibrium outcome, the incumbent should under-invest in advertising and maintain a bhungry
lookQ in order to deter entry.
We now formulate the advertising and price competition situation associated with the game
G. Following Greenberg (1990), let p a X be any currently proposed price pair. Firm i can object
to this proposal and binduceQ another price pair by unilaterally selecting any other price from its
set of prices X i . The set of prices that can unilaterally be induced by firm i a N is specified by an
inducement correspondence, mapping X to X as follows,
n
o
ci p pV jpVj pj ; pVi aXi ; ipj:
7
The correspondence (7) states that firm i can induce the outcome pV from p = ( p 1, p 2) by
setting a new price p iV a X i , given that the firm j sticks to p j . The advertising and price
competition situation is the quadruple (N,X,{P}i aN ,{c i }i aN ).
A standard of behavior r is a mapping that assigns to every pair of prices p a X a subset
of { p}, denoted by r( p). We call such a subset a solution. Note that the solution to the

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157

outcome p is either { p} or the empty set F. In the former case, where the solution is
non-empty, we say that the pair of strategies p is bsupportedQ or bacceptedQ by the standard
of behavior r. The above definition of the standard of behavior is arbitrary. Thus some
stability criteria must be imposed on a standard of behavior if it is to be followed by a
rational firm.
Definition 2. A standard of behavior r is internally stable if for all p a X, p a r(p) implies that
there do not exist a player i a N and a pair of strategies pVa c i (p) such that p Va r(pV) and
T i (p V) N T i (p).
The above criterion postulates that if the pair of strategies p is supported by a standard of
behavior r, then no player should be able to induce another outcome pV, which is also supported
by r and makes him better off. On the other hand, the following criterion states the condition for
exclusion of an outcome from a solution. Accordingly, if an excluded pair of strategies were
included in the solution, then internal stability would be contradicted.
Definition 3. A standard of behavior r is externally stable if for all p a X \ r(p) there exist i a N
and a pair strategies pVa c i (p) such that p Va r(p V) and P i (p V) N P i (p).
Definition 4. A standard of behavior r is stable if it is both internally and externally stable.
For any standard of behavior r, let r(X) be the set of strategy pairs supported by r, i.e.,
r X vpaX r p. This is the set of all strategies permissible by the standard of behavior r.
The following result states that a standard of behavior that supports the set of strategies identified
by anyone of the best response functions is stable.
Proposition 2. For any i = 1,2, let w i be a one-to-one function. Then the standard of behavior r,
where r(X) = {p a X|p i = w i (p j )}, i, j = 1,2 i p j, is stable.
Consider anyone of the best response functions, for example w 1. Because w 1 is a one-to-one
function, none of the firms can induce a pair of prices, supported by r, from another pair of
prices which is also supported by r. Thus, r is internally stable. On the other hand, from
any pair of prices that is not supported by r, firm 1 can choose its best response price,
inducing a pair of prices that is supported by r. By choosing such a price, firm 1s profit
also increases.
Let p 2 = k( p 1) be any strictly increasing function (as illustrated in Fig. 1) such that p 2 = k(p 1),
w 1 1( p 1) b k( p 1) b w 2( p 1) for p 1 b p 1 and w 2( p 1) b k( p 1) b w 1 1( p 1) for p 1 N p 1.4 The assumption
of existence of Nash equilibrium ensures the existence of such a function.
Proposition 3. Consider the advertising and price competition game G and its associated
situation. The standard of behavior r such that r(X) = {p a X|p 2 = k(p 1 )} is stable.
The above proposition indicates that any strictly increasing function that lies between the two
best response functions is stable. This proposition is at the heart of our contribution upon which
the next two results are derived.
Let b be the set of Pareto optimal prices, i.e. b = { p a X|Z p Va X such that P i ( p V) N P i ( p) for
every i a N}. Geometrically, these prices are the locus of tangent points of iso-profit curves of
the two firms. We depict these points in Fig. 2.

We denote the inverse of w i ( p j ) by wi 1( p j ).

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H. Beladi, R. Oladi / Mathematical Social Sciences 51 (2006) 153161

p2

2
N

p 2

p 1

p1

Fig. 1.

Proposition 4. For every p a b there exists a stable standard of behavior r that supports p, i.e.,
p a r(p).
The above result is a general contribution to the price competition literature. Accordingly,
assuming product differentiation, the Pareto optimal prices are stable. More specifically, there
exist some stable prices p a b, such that p i N p i , and P i (p ) N P i (p ),i = 1, 2. That is, there exist
some stable prices that bPareto dominateQ the Nash equilibrium prices.
As stated earlier, Proposition 3 indicates that all outcomes between the two best response
functions are supported by some stable standards of behavior. That is, the stable post-entry
set of prices includes soft as well as fierce competition. Soft competition relates to the
pairs of stable prices that are greater than the Nash equilibrium prices while fierce
competition is associated with pairs of stable prices that are less than the Nash equilibrium
prices. Thus, we have the following corollary which is in sharp contrast to the generally
held view in the literature that heavy advertising encourages entry. More specifically, it

p2

2
N

p1
Fig. 2.

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159

states that an incumbent can have a captive market and yet could select a low stable price
in order to deter.5
Corollary 1. The incumbent need not maintain a blean and hungry lookQ in order to deter entry.
More specifically, the bfat-catQ who seeks stability can deter entry.
4. Concluding remarks
We use the theory of social situations (Greenberg, 1990) to examine the fat-cat effect and
stability in an advertising and price competition game. In this game, an incumbent invests in
advertising in the first period and faces possible entry of a new firm and price competition in the
second period. As in Fudenberg and Tirole (1984), we consider both exogenous and endogenous
advertising.
We derive the stable prices supported by stable standards of behavior. As the main result of
this paper, we show among other things that the incumbent need not maintain a hungry-look
(under-invest in advertising expenditure) in order to deter entry. This is in sharp contrast to the
common conclusion in the literature on advertising that the incumbent cannot deter entry by
heavy advertising due to the fat-cat effect.
Our new approach in modeling advertising and its impacts on competition can be used in an
alternative form of competition. One could use post entry quantity competition rather than price
competition. Moreover, the new model presented in this paper can be extended in many other
directions. Using our framework, one may examine strategic advertising and competition in a
vertically differentiated market. Finally our analysis provide an alternative theoretical foundation
for empirical studies of advertising expenditures and its effects on competition.
Appendix A. Proofs
Proof of Proposition 2. Internal stability: Since w i is a one-to-one function, for any p a X,
p a rX( p), no player can induce another strategy pair, pV a X, p p p, such that r( pV) p F.
External stability: For any p a X \ r( p), p i p w i ( p j ), i, j = 1,2 i p j, due to definition of r. Then,
player i can induce pV = ( p iV, p j ) such that pVi = w i ( p j ), where P i ( pV) N P i ( p). This inequality is
due to the definition of best response function. 5
Proof of Proposition 3. We have to show that r as defined in the proposition is both internally
and externally stable.
Internal stability: Since k is strictly increasing, if pV a r( pV), implying that p 2V = k( p 1V), then for
any pW p pV such that pWi a X i and pWj = p jV, i, j = 1, 2, i p j, we have p 2W p k( p 1W), i.e., all strategies that
player i can induce have empty solutions. The internal stability follows immediately.
External stability: Define p i = g i ( p j ) i, j = 1,2, i p j such that for pV, pW a X where p jV = pW,
j
p 2V = k( p 1V), pWi = g i ( pW),
we have P i ( pV) = P i ( pW). The function g i maps all points symmetric
j
(around w i ) to points mapped by k. Now assume that p a X \ r( p) and consider the following
cases:
Case 1: p 2 b p 2
Sub-case 1.1: p 1 b k  1( p 2). By definition of k, p 1 b k  1( p 2) b w 1( p 2), which implies that for
p where p 2 = p 2 and p 1 = k  1(p 2) N p 1, P i (p ) N P i ( p). The last inequality is due to the definition

All our results analysis will also be valid if one considers an endogenous choice of a.

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of w 1, i.e. BPBp1 1p N 0 if p 1 b w1( p 2). Note also that p a c 1( p) since this position is induced by a
unilateral price increase by firm 1. Moreover, by construction we have p a r( p).
Sub-case 1.2: p 1 N g 1( p 2). By symmetric assumption of P 1 around the best response function
w 1, we have P 1(p ) N P 1( p), where p 2 = p 1 and p 1 = k  1(p 2) b p 1. Moreover, we have p a r(p ) as
in Sub-case 1.1, and p a c 1( p) since firm 1 decreases its price unilaterally.
Sub-case 1.3: k  1( p 2) b p 1 V g i ( p 2). Construct p where p 1 = p 1 and p 2 = k(p 1). Consider the
following possibilities: (1) p 1 b p 1 : By definition of k, k( p 1) b w 2( p 1) for all p 1 b p 1. Also
k  1( p 2) b p 1 implies that k( p 1) N p 2 since k( p 1) is strictly increasing. Therefore, we have
( p 2) b k( p 1) b w 2( p 1). It follows by construction that ( p 2) b p 2 b w 2( p 1). Next, recall from the
definition of w 2 that for any given p1 BPBp2 2p N0 if p 2 b w 2( p 1) This implies that P 2(p ) N P 2( p), as
we already established that p 2 = k(p 1) b w 2(p1). That is, as firm 2 increases its price closer to its
best response price, its profit increases. (2) p 1 N p 1 : Then p 2 b g 2( p 1) since g 1 and g 2 intersect
only at Nash equilibrium due to definitions of g i and k. It follows from construction of p and
definition of g 2 that P 2(p ) N P 2( p) because of symmetric assumption of P 2 around the best
response function w 2. Finally, under both possibilities 1 and 2, p a c 2( p) since p is induced
through a unilateral increase in price by firm 2.
Case 2: p 2 N p 2
Sub-case 2.1: p 1 N k  1( p 2). By definition of k, p 1 N k  1( p 2) N w 1( p 2). This implies that for p
such that p 2 = p 2 and p 1 = k  1(p 2) b p 1, P 1(p) N P 1( p). The reason for the last inequality is
similar to that of Sub-case 1.1. Also, p a c 1( p), as firm 1 unilaterally reduces its price.
Sub-case 2.2: p 1 b g 1( p 2). By symmetry of P 1, we have P 1(p) N P 1( p) where p 2 = p 2 and
p 1 = k  1(p 2) N p 1. In addition, p a c 1( p) since firm 1 increases its price unilaterally.
Sub-case 2.3: g 1( p 2) V p 1 b k  1( p 2). Construct p where p 1 = p 1 and p 2 = k(p 1). Consider the
following two possibilities: (1) p 1 N p 1 : p 1 b k  1( p 2) implies that p 2 N k( p 1) since k( p 1) is strictly
increasing. Also for all p 1 N p 1, we have k( p 1) N w 2( p 1) due to definition of k( p 1) (see Section
3). Therefore, we conclude that p 2 N k( p 1) N w 2( p 1). Then, by construction of p, we have
p 2 N p 2 N w 2( p 1). This implies that P 2(p ) N P 2( p) because for any given p 1, BPBp2 2p b 0 if
p 2 N w 2( p 1). That is, if firm 2s price is greater than its best response price, the firm could
increase its profit by lowering its price closer to its best response price. (2) p 1 b p 1 : Since g 1 and
g 2 intersect only at Nash equilibrium due to definitions of g i and k, we have p 2 N g 2( p 1). This,
along with the symmetry of P 2 around the best response function w 2, implies that
P 2(p ) N P 2( p). Finally, with both possibilities, p a c 2( p) since p is induced by firm 2 reducing
its price unilaterally.
Cases 1 and 2 imply external stability of k. 5
Proof of Proposition 4. 8 pVa b choose a function k, as defined earlier, such that p 2Vk( p 1V).
Then based on Proposition 3, the standard of behavior r with r(X) = { p a X|p 2 = k( p 1)} is
stable. 5
Proof of Corollary 1. Directly from Proposition 3.

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