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KENNETH J. ARROW GEORGE G. STIGLER ELISABETH M. LANDES ANDREW M. ROSENFIELD
LEXECON INC. CHICAGO, IL AUGUST 1990
Copyright 1990 O The Advertising Coalition (aka The Advertising Tax Coalition)
ADVERTISING AND COMPETITION............................................................... 8 A. ADVERTISING AND SEARCH COSTS.................................................... 8 1. 2.
THE EFFECTS OF ADVERTISING ON PRICE................................ 11
ADVERTISING AND INFORMATION............................................ 12
EXTERNAL BENEFITS AND THE INCENTIVE TO ADVERTISE.......16
ADVERTIS~NG D MARKET ENTRY.................................................. 17 AN
THE DURABILITY OF ADVERTISING............................................................19
REVIEW OF EXISTING LITERATURE ON DURABILITY ..........................22
A RE-EXAMINATION OF EXISTING STUDIES........................................ 26 1. 2.
KOYCK AG MODELS............................................................... 27 L
HIRSCHEY 'S METHOD.............................................................-29
WE DRAW FROM THIS? ................................... 35
W H A T LESSONS CAN
TABLE OF TABLES AND FIGURES
Breakdown of Industrial Company Marketing Costs for SIC Industries with 10 or More Respondents
Total Selling, Advertising and Promotion Costs for Selected Companies (1 985-1987)
Total U.S. Advertising Dollars by Media
Survey of Econometric Sales -- Advertising Analysis
Summary of Advertising Capital Depreciation Rates Found in the Recent Literature
Regression of Tobin's Q on the Advertising to Sales Ratio by Year 1977 to 1986 Potential Effect of Omitted Variables on Estimated Coefficient
LIST OF APPENDICES
ORGANIZATIONS AND COMPANIES SUPPORTING THIS STUDY
ADVERTISING AND ENTRY: THE LITERATURE
ESTIMATING A KOYAK
LAG MODEL WITH POOLED DATA FROM
TECHNICAL APPENDIX (AVAILABLE UPON REQUEST)
I. 11. 111. IV. V.
INTRODUCTION TO REGRESSION ANALYSIS REGRESSION
OUTPUT: TOBIN'S Q
DATA APPENDIX: TOBIN' Q s
REGRESSION OUTPUT: KOYCK AG L DATA APPENDIX: KOYCK LAG
There is no chestnut more overworked than the critical whinny: "Advertising sells people things they don't need."
We, as one agency, plead guilty. Advertising does sell people things they don't need. Tlings like television sets, automobiles, catsup, mattresses, cosmetics, ranges, refrigerators, and so on and on. People don't really need these things. People don't really need art, music, literature, newspapers, historians, wheels, calendars, philosophy, or, for that matter, critics of advertising, either. All people really need is a cave, a piece of meat and, possibly, a fire. The conlplex thing we call civilization is made up of.1uxuries. An eminent philosopher of our time has written that great art is superior to lesser art in the degree that it is "life-enhancing." Perhaps something of the same thing can be claimed for the products that are sold through advertising. They enhance life, to whatever degree they can.
Young & Rubicarn, Advertising
ECONOMIC ANALYSIS OF PROPOSED CHANGES I N THE T AX TREATMENT
Lexecon Inc. is a consulting fm that specializes in the application of economics to legal and regulatory issues. Our affiliates include Kenneth Arrow of Stanford University, winner of the Nobel Prize in Economics in 1972, and George Stigler of The University of Chcago, winner of the Nobel Prize in Economics in 1982. Lexecon and Drs. Arrow and Stigler were asked to examine the economic effects of proposed changes in the tax treatment of advertising expenditures. Our findings are set forth below.
Existing tax law treats the cost of a advertising as a current expense, and thus advertising expenditures may be deducted from income in the year in which they are incurred. It has been suggested that the law be changed to require that at least some portion of the advertising costs incurred in a particular year be amortized and hence deducted from income over several years. Support for this change appears to be based on two mistaken views of advertising:
First, that advertising is wasteful and should be discouraged, and Second, that advertising generally produces benefits that last for more than one year, and
thus expenditures on advertising should be deducted from income over time in order to produce a more accurate rnatckg of P i g of business expenses md the income they generate.
Based on an analysis of the issues and a comprehensive review of the existing literature in the field, we conclude that proposals to change the tax treatment of advertising are not supported by the economic evidence.
F r t advertising provides important economic information to consumers and others and is,
thus serves an important procompetitive function in society.
Second, it is nearly impossible to generalize about the durability of advertising, and in any
event the existing economic evidence does not support the conclusion that advertising is longlived.
Advertising offers many benefits to both the consumer and the economy as a whole.
Advertising is a powerful tool of competition. It provides valuable information about products and services in an efficient and cost-effective manner. In this way advertising helps the economy to function smoothly -- it keeps prices low and facilitates the entry of new products and new firms into the market. Economists have long recognized the role of advertising in providing information. The basic economic model of perfect competition assumes that consumers have perfect information. In an early article, however, Stigler showed that consumers rarely have such information -- hence the need for advertising. Without advertising consumers would have to search on their own for information about the existence and identity of producers and the prices, qualities, and other characteristics of the products they sell. But with advertising, this information is provided efficiently and inexpensively. Reliable studies have found that advertising helps reduce both the level and the dispersion of prices, an effect that is universally held to be beneficial. Even so-called "image" advertising conveys information about product quality and thus benefits consumers. Some advertising
promotes not only the firm, but also the industry in which the fm participates. In such cases, advertisers can reap only a part of the benefit of any advertising they do. Thus there may be "too little" incentive for firms to advertise and hence "too little" information provided. Since the information conveyed by advertising is valuable, one must be particularly cautious about taxes that would raise the cost, and hence lower the quantity of advertising. Such taxes would reduce the overall flow of economic information available to consumers. As a result, we expect that prices would rise, the dispersion in prices for particular products would increase, and consumers would be less able to find goods that satisfy their preferences.
The existing economics literature does not provide reliable evidence to support the notion that advertising is long-lived.
Over the past three decades, there have been many studies of the durability of advertising. Some suggest that the effects of advertising are relatively short-lived. Others suggest that the effects are relatively long-lived. These studies arrive at such different conclusions about the durability of advertising that they cannot be used as a coherent basis for formulating tax policy. Moreover, we have found that these studies suffer from technical flaws that render their conclusions meaningless. Proponents of a change in the tax treatment of advertising frequently cite an article by George Mundstock who, in turn, cites work by Mark Hirschey and Jerry Weygandt to support his conclusion that advertising creates long-lived capital assets. Hirschey and Weygandt begin with the hypothesis that the market value of any fm reflects all factors -- both tangible and intangible -- that will have a systematic effect on future profitability. Under this hypothesis, if advertising creates future value, it will be reflected in the ratio of the market value of the firm to the replacement value of its assets. Thus, the value of the f m ' s intangible capital which,
according to Hirschey and -Weygandt, should include advertising, would be its market value less the value of its tangible assets.
Hirschey and Weygandt developed a model to measure the relationship between a firm's
that there are many economic factors, other than advertising, that determine the market value of a firm. The most important of these is the value of the firm's product -- that is its effectiveness or its "innovativeness." Advertising is only a means by which the firm can fully market the value of that product. A simple example helps to illustrate this point. Apple computer developed an innovative user interface, called the "Finder," which it provides on its Macintosh personal computers. The interface has been enormously popular, and Apple has realized its value by advertising its advantages to potential users. As a result, Apple's sales have soared, as has its market value. But Apple's advertising is not the intangible asset here -- it is only a tool that has helped Apple realize the value of the true intangible asset, the quality and innovativeness of the Finder. Even if the Hirschey and Weygandt model had been able to account for these intangible factors, which it has not, it still suffers from serious theoretical problems. Because of the way the model is constructed, the authors must assume all firms are in a steady state, and consequently, both the rate of growth of advertising expenditures (growth rate) and the rate at which advertising loses its impact (depreciation rate) remain constant from year to year. Hirschey and Weygandt must also assume that, although the growth rates and depreciation rates vary among firms, the sum of the two rates must be the same for all firms. Without this restriction Hirschey and Weygandt could not attribute differences in advertising "capital" to differences in advertising expenditures. However, this assumption forces there to be an inverse relationship between growth rates and depreciation rates, so that firms that increase their advertising more rapidly would hypothetically also have to have advertising that is longerlived or more durable. This assumption has no basis in theory. Thus, any estimate of the durability of advertising based on Hirschey and Weygandt's work is literally meaningless.
Existing economic evidence does not support proposed changes in the tzx treztment of advertisin
Our work points out how very difficult it is to obtain any general measure of the durability of advertising. In part, this is probably due to the fact that advertising is an extremely heterogeneous product and thus is not easily measured; and in part, it is probably due to the fact that economists do not yet have a good testable model of the way in which advertising affects sales. In either event, we do not believe that existing economic evidence supports proposed changes in the tax treatment of advertising.
ECONOMIC ANALYSIS OF PROPOSED CHANGES IN THE T P !TREATMENT OF PBWRTHSlRG EXPENDETWi
We have been asked to examine the economic effects of a proposed change in the tax
treatment of advertising.' Like many other business items, advertising is treated as a "current expense" under the Internal Revenue Code, and thus advertising expenditures are "written off' or deducted from income during the year in which they are incurred. Recently, however, it has been suggested that Federal tax rules be changed so that advertising costs would no longer be "expensed," but would instead be amortized and consequently deducted from income over time. The result of such a change is obvious: an increase in the cost of advertising and a corresponding
decrease in the amount of advertising.2
Support for changing the tax treatment of advertising seems to be based on two mistaken
ideas: (1) that advertising is "harmful" (or, at a minimum, wasteful) and thus should be
Dr. Kenneth J. Arrow received the Nobel Prize in Economics in 1972 for his work on social choice and general equilibrium. Dr. George J. Stigler received the Nobel Prize in Economics in 1982 for his work on the theory of information. EIisabeth M. Landes and Andrew M. Rosenfield are Vice President and President, respectively, of Lexecon Inc., a consulting fum that specializes in the application of economics to legal and regulatory issues. The empirical work presented in Section I11 and in Appendix D to this study were carried out at Lexecon under the direction of Ms. Landes and Mr. Rosenfield. The organizations that supported the preparation of this study are listed in Appendix A. Some people have suggested that the change would have only a short-run effect because, after some "phasein" period, the total deduction for advertising in any one year would be approximately the same regardless of whether advertising had been expensed or depreciated. Their argument is the following: if the law were to specify that advertising be written off over five years (say, 20 percent this year and 20 percent each year for the next four), the change would have no effect after the fifth year because a dollar spent would be matched by a dollar deducted. But this argument is incorrect: Amortizing expenditures of, say, $1,000,000 on advertising over five years results in a tax payment of $272,000 in the first year, and tax savings of $68,000 in each of the four fo!!owing years (at a 34% marginal tax rate). The value of the tax payments and savings over the five years is not their simp!e tctal, but rather the present vnlue of $272,000 paid this year and $05,000 saved LI ezch of the next four years. At a 10% discount rate, this represents a net tax payment of more than $56,000, or a 5.6% tax on advertising expenditures. A fm bears this tax each year in which it advertises. Put differently, the deduction from spending in previous years is irrelevant in deciding how much to spend this year because the firm will get that deduction no matter how much it spends this year.
discouraged and (2) that advertising is generally long-lived and thus, under an efficient tax system, should be capitalized rather than expensed. Based on our review of the existing literature in the field and our own analysis of the issues, we conclude that: a. Advertising is an efficient way to provide important economic information to consumers and others; b. Because its central role is to provide information, advertising is beneficial, not wasteful; c. It is nearly impossible to generalize about the durability of advertising, but, in any event, the available economic evidence does not support a view that advertising is long-lived; and d. In short, the proposed change is not supported by the economic evidence, and, moreover, it appears likely to lead to economic inefficiencies. Certainly, some economists have expressed the view that advertising is " h a r d . " 3 Traditionally, the hostility derives from the early models economists used to describe markets. The model of "perfect competition" (which was thought to be the "ideal" structure for a market) posits that all like goods are identical, so that consumers cannot distinguish among them. The paradigm is the market for wheat. Essentially, red #2 winter wheat is red #2 winter wheat, no matter which of the many thousands of farmers grows it. Although advertising might expand the total market for wheat, no individual farmer has an incentive to advertise because he would receive only his pro rata share of the increase in sales (vastly less than a penny for every dollar expended). It would only pay the individual farmer to advertise if he had such a large share of total sales that he would capture most of the benefits of his advertising.
T this textbook mode!, advertising is not compatible with competition. In fact, many n
early economists believed that advertising was synonymous with the absence of competition and,
In this context, "harmful" does not refer to advertising of harmful products: instead, it refers to the sometimes-stated (and, in our opinion, incorrect) view that advertising causes people to buy things that they neither want nor "need."
om that premise, came to the opinion that advertising is an instrument to suppress competition by, for example, increasing "socially wasteful" brand loyalty or erecting artificial barriers to entry.4 This thinking was based (at least implicitly) upon a view of markets that assumed everyone knew everything from birth: who sold what; the qualities of goods, including brand new goods; the current prices of goods -- even if they changed every hour. In such a world, tomorrow's Oat Bran Cereal would be as well known as today's Corn Flakes. But, we do not live in a such a world. Thus, the question is: What is the role of advertising in the world in w h c h we do live? The role of infonnation in enhancing consumer welfare is widely recognized in economics. In fact, according to a recent study by Ippolito and Mathios of the FTC, "[iln markets where conditions are changing rapidly, the flow of information to consumers becomes a primary determinant of welfare."5 In the modern economy, advertising provides information about products and services. By providing infonnation in an efficient (i.e., cost-effective) manner, advertising helps the economy to function smoothly -- it lowers prices and aids new products and even firms to enter the marketplace. In short, advertising is a p o w e f i I tool of competition: competition of one product against another and competition of one finn against another. The role of advertising in providing information is clearly illustrated by the results of the Ippolito and Mathios study. The authors of this study examine sales of ready-to-eat cereals as a function of information available about the health benefits of eating high-fiber cereals. For a
period of time even after the information about these benefits became available, their advertising was prohibited; this prohibition was later lifted. Because of this change in the regulation, the authors were able to use a "before-and-after" test to examine the effects of the advertising on consumer and producer behavior.
For a broader overview, see the discussion in Section II.B, iifra, at 26.
Ippolito and Mathios, Information, Acfvertising andHealth Claims: A Study of the Cereal Market, Federal Health Claims in Advertising ai7d Trade Commission (unpublished paper) (Nov. 1989). See also, , Labelling: A Study of the Cereal Industry, Bureau of Economics Staff Report, Federal Trade Commission (Aug. 1989).
Their results indicate that consumers switched to products with higher fiber content once
apparently also lead to significant product innovation without m y adverse effect in other product dimensions related to health. Finally, (and perhaps most to the point here) the results
of this study suggest that advertising was an important factor in providing information to these consumers. In fact, although the information had been available through governmental and other general sources, it had had limited impact on consumer choice in the years before advertising was permitted. The study concludes that advertising was particularly effective because it lowered the costs of acquiring information for broad segments of the population. Some advertising promotes not only the fm that does the advertising, but also the industry in which the firm participates. This is particularly true of new products. For example, if one fm advertises facsimile ("FAX ') machines, it will tend to promote the sales of FAX machines made by other firms as well as those made by the finn that does the advertising. In such cases, because the advertiser can reap only a part of the return from his advertising, there may be too little incentive for firms to engage in advertising. One must be particularly cautious about taxes that raise the cost of such advertising and thereby dampen even more the incentives to engage in it. Whde we believe that much of the potential support for changing the tax treatment of advertising stems fiom an underlying hostility to advertising, there also seems to be support fiom those who believe that advertising is an "investment" in the fiture. One of the stated goals of the
1986 Tax Reform Act was to "level the playing field," i.e., to ensure that al types of business l
investment are taxed equally. By definition, investment occurs whenever a business gives u p current sales (or profits) in the hope of increasing future sales (or profits). Spending on new plant and equipment is perhaps the most obvious, but not the only, form of investment. Other expenditures -- such as spending on research to develop new products, on worker training, or even on employee benefits -- may also result in greater future profitability.
machines, is depreciated (and hence deducted from income over a number of years); spending on "intangibles," such as R&D and advertising, is generally deducted from income in the year in which it occurs. Proponents of the proposed change in the tax treatment of advertising (and perhaps other intangibles as well) argue that if advertising has a "long" (i.e., longer than one year) economic life, the current tax law results in a bias in favor of investment in intangible capital. Thus, much of the debate centers on whether the effects of advertising are truly long-lived. In the past two or three decades, there have been a number of studies on the durability of advertising. Many of the earlier studies (and some of the more recent ones as well) suggest that the effects of advertising last for many years. We have examined these studies and find that they suffer from serious technical and conceptual flaws. Because of these flaws, it would be
inappropriate to rely on their conclusions as a basis for public policy. Moreover (and perhaps just as important), there are a number of other studies that suggest just the opposite. In short, we do not believe that the currently available economic evidence allows one to conclude that advertising creates a long-lived capital asset. In addition, we believe that any tax change that makes advertising more costly may well have unintended (and undesirable) consequences. First, it will induce finns to switch to other forms of selling and promotion that are less economically efficient or perhaps to switch advertising in-house where it can be treated as part of general overhead. Second, because much advertising is provided together with relatively inexpensive information (e.g., newspapers or magazines) or with "free" entertainment or information (e.g., television or the yellow pages), a .tax on advertising may well reduce the availability of such information and entertainment. Finally, the tax may reduce the overall flow of information in the economy and thereby result in higher (and less uniform) prices.
Our report is organized as follows. In Part I, we provide some background on advertising.
In Part 11, we discuss the economic theory of advertising. We show that advertising provides information efficiently and thus benefits consumers and society as a whole. In Part 111, we
examine the issue of durability. First, we review existing economic studies and show that many of them contain statistical or theoretical flaws that render their conclusions meaningless. Second, we show how some of these errors are largely responsible for those longer durations found in the literature, and how correcting for these errors would lead to significantly shorter estimated durations. Finally, we present our conclusions.
im Virtually every fr in the country advertises in some way, even if it is nothing more than
putting up a sign on a bulletin board. Last year advertisers in the United States spent
approximately $125 billion.6 There is a tendency to think of advertising as an item on television or in the newspaper that exhorts people to buy this product or that product. But this is only one type of advertising. A substantial fraction of all advertising is "trade" or business-tobusiness advertising designed to inform potential business customers of various products or services that they might use as inputs in their production processes. Discussions of advertising tend to be carried on as if advertising were a well defined commodity. This is far from the truth. Advertising is simply one of many marketing techniques available to modern firms. Others include promotions, publicity or public relations, and personal selling such as in-store demonstrations, each of which may contain elements that make it virtually
im indistinguishable from what we consider advertising7 For example, is it advertising when a fr
places a coupon in the newspaper entitling the holder to 50 cents off on some product? Or, is it advertising when a corporation sponsors a sporting event with the proceeds going to charity? Should the brand or company logos on trucks or tee shirts be treated as advertising?
McCann-Erickson estimate as reported in Lipman, "Advertising: Spending Augers Ho-Hum 1990," Wall St. J., Dec. 12, 1989.
See, e-g., P. Kotler, Marketing Management, 6th ed., 588 (1988).
strate, it is very difficult to determine where to draw the line between advertising and other foims of selling and promotion. There are other ways to illustrate this. If we examine the way major industrial companies in the United States spend their
marketing communications budgets, we see that they have a wide variety of alternatives and that, in general, their choices vary by the industry in which they participate. (See Table 1.) For example, print advertising is twice as large a part of marketing comrnunications expenditures in electronic equipment and computers as it is of furniture and fixtures.
An alternative way to show the variation across companies in the use of advertising is to
examine advertising and promotion as a percentage of total selling costs. Here we see that these percentages vary widely across f m s and often change substantially from year to year for the
im same f r . For example, Lotus Development C o p spent 28 percent of its total selling and
marketing budget on advertising and promotion in 1985 but only 1 7 percent in 1987. (See Table 2.) And, Lotus devotes a very different fraction of its selling and marketing budget to advertising than do Ashton-Tate and Management Science America, even though all three firms are in the same business. Any proposal to change the tax treatment of advertising must define the expenditures that will be covered by the proposal. The narrower the definition that is used, the easier it will be for firnls to "avoid" the tax by switching to other forms of selling and promotion. On the other hand, if advertising is defined very broadly, the change in the tax treatment is likely to have an adverse effect on all activities included under the definition, including those (such as coupons and price promotions) that are clearly short-lived and offer immediate and direct benefit to consumers in the form of reduced price.8 Even if one defines advertising narrowly as, say, media advertising, it is still a heterogeneous commodity, with differences that make any given rule difficult to implement. For
Much advertising contains information about price. Economists agree that such information is valuable to consumers and, moreover, that it leads to competition (and lower prices) in the marketplace. In addition, it tends, by its very nature, to be relatively short-lived.
example, ifthe rule is that advertisers will be required to depreciate all advertising that does not contain information on price, advertisers will simply include price in all their advertisements. One might think (wrongly, we believe) that one way around this would be to tax television advertising on the grounds that it tends to be primarily "image" advertising and therefore (they claim) long-lived.9 But, again, this will simply induce switching. If one examines the
composition of spending by media, one finds that virtually all firms use a combination of various media to carry their advertising messages. (See Table 3.) Thus, if one were to arbitrarily tax television advertising only, advertisers would presumably switch to other vehicles. In short, whatever one thinks of the theoretical merits of the proposed change, in practice it is likely to be an administrative nightmare. If advertising is narrowly defined, a tax may be manageable, but it will not raise much revenue -- and it will cause a good deal of dislocation (and inefficiency) in marketing. If advertising is broadly defined, it will again lead to gross
ineffkiencies by placing extraordinary burdens on the flow of infcrmation about products and their characteristics (e-g., price, quality, the identity and location of suppliers) that are unambiguously beneficial to consumers and competition. Moreover, as we discuss below, we believe that the theoretical arguments in favor of the proposed change are not supported by the economic evidence.
11. ADVERTISING AND COMPETITION
ADVERTISING AND SEARCH
Advertising is a method of distributing economic information efficiently. One usually associates advertising with consumer goods, but it is truly ubiquitous: it is used by almost every
Of course, much television advertising (especially that shown on local broadcasting) does contain information about price. Moreover, as we explain below, so-called "image" advertising also provides consumers with valuable information.
type of enterprise for highly varied purposes. Banks and mutual funds exhort us to save and tell us of the safety, prospects, and current yields of deposits and investments; companies advertise job opportunities; colleges and universities advertise for students; and the U.S. Armed Forces advertise for recruits. Whether the desired customers are consumers, engineers, manufacturers, prospective employees, or city purchasing agents, advertising is a common method of identifying sellers and describing their wares. Advertising provides information about products and services. The information may be only that the product exists or it may be information about the product's qualities, such as taste or durability, which might not be otherwise available without buying and sampling the product. Some advertising provides information about price or about where the product may be purchased. Other advertising associates a product or service with a particular image or feeling, which may enhance consumer enjoyment of the product. Some types of advertising, particularly price advertising, may be firm-specific -newspaper ads for weekly food specials provide little information except that a product is available at a particular store for a particular price. (Some may also contain information on how that price compares with other prices in the market or with the usual selling price for the product.) The effects of such advertising are usually very short-lived because prices change frequently. In contrast, much non-price advertising is not firm-specific -- instead one firm's advertising may benefit other firms in the industry by increasing overall product awareness or by providing information on the general product rather than on a spec& brand. This is especially true of new products. The role of advertising in providing information has long been recognized by economists. In an early article, Stigler showed that the basic economic model of perfect competition, which rests on the assumption that consumers have perfect information, rarely obtains in the real world
-- if it did, there would be no need for advertising. Stigler, The Economics o Information, 69 J. f
Pol. Econ. 213 (1961). The need for information arises because, without it, consumers would be
lity, availability, or other product characteristics. If consumers had all this information, advertising would be unnecessary. Individual consumer search, word-of-mouth advice, or infornlation £rom intermediaries, such as Consumer Reports, may appreciably reduce the uncertainty about products and their characteristics, but for many products, advertising is by far the most efficient way to reduce consumer ignorance. For example, price information published in newspapers or broadcast on the radio informs consumers in a way that is vastly less costly to them than is travelling from store to store and comparing prices. Similarly, classified advertisements and entries in the Yellow Pages allow sellers to reach (inexpensively) those persons seeking to buy their products.I0 Without advertising, consumers would have to search on their own for information about the existence and identity of sellers and the prices they charge. Thus, Stigler concludes that advertising is procompetitive. Even though "advertising is treated with a hostility that
economists normally reserve for tariffs or monopolists," it is a method of providing potential buyers with knowledge of the identity of sellers [and] is an immensely powerful instrument for the elimination of ignorance. The effect of advertising on prices . . . is equivalent to that of the introduction of a very large amount of search by a large portion of potential buyers. It follows . . . that the dispersion of asking prices will be much reduced. Since advertising of prices will be devoted to products for which the marginal value of search is high, it will tend to reduce dispersion most in commodities with large aggregate expenditures. Stigler, id. at 224. Advertising is a particularly eflicient way of economizing on consumers' search costs because it has aspects of a public good, i.e., a good that can be consumed by more than one consumer at little or no additional cost (beyond that necessary to supply the first few consumers). A television advertisement is available to as many as wish to view it (or, more accurately, as many as wish to view the program during which it is broadcast), and there is
Classified Yellow Pages directories not only dramatically reduce consumer search costs, but also are the principal media through which many small f m s inform consumers of their goods and services.
nothing extra required of the advertiser when additional households tune in. In contrast, if each consumer has to search for prices (or qualities) individually, the total cost will be proportional to the number of consumers searching. Thus, it is usually more efficient to disseminate
pricelquality information by advertising than to rely on search by individual consumers.
Several empirical studies have attempted to measure the extent to which advertising lowers the cost of determining prices charged at different retail outlets and thereby results in lower market prices. One study found that eyeglass prices in 1963 were significantly lower in states that allowed advertising of eyeglasses than in states that did not. Benham, The Efect o f Advertising on the Price o Eyeglasses, 15 J. Law & Econ. 337 (1972). f methodology used, Benham found that: advertising restrictions in this market increase the prices paid by 25 per cent t o more than 100 per cent. Furthermore, these estimates are likely to understate the total savings to consumers occasioned by advertising, since the search process itself is less expensive when information is more readily and cheaply available. Benham, id. at 344-345. There have also been a number of studies of the effect of food-price advertising on average market price and the variance in market prices. A 1974 experiment in Canada compared prices before, during, and after a brief period in which price information was published or mailed to consumers in one city but not in a second (control) city." The study found that during the time Depending on the
See - Devine and Marion, The li.2jlueiice of Consumer Price Information on Retail Pricing and Consuiner Behavior, Am. J. of Ag. 228 (1979); Devine, A Review of the Experinzental Effects of Increased Price Ii?fomatioii 017 the Perjbrmance of Calladial7 Retail Food Stores in the 1970's, 26 Canadian J . Ag. Econ. 24 (1 978); and Marion, The lrnpacl of Market Information on Competition: Theoretical and Empirical Considerations, paper presented at a public hearhg on brokerage charges and services conducied by the Wisconsin Commissioner of Securities, Milwaukee, Wisconsin, September 11, 1979. See also, Lesser and Bryant, The Influence of Consumer Price hforinafion on Retail Pricing and Consumer Belzavior: Conzme17t, Am. J . Ag. Econ. 265 (1980) and Devine and Marion, The lnjluence of Consumer Price Injbrmatioii On Retail Pricing and Conszm~er Behavior: Reply, 267 (1 980).
available, prices in the test city were 6.5 percent lower than those in the control city, but once the price information was no longer available, prices in the test c returned to pre-experiment levels. In addition, during the period of the experiment, price dispersion across sellers was reduced and low-priced chains increased their share of sales. These results were subsequently c o n f i e d in two separate experiments, one involving other Canadian cities and another in four pairs of cities in the United States. In the U.S. study, prices were 0.2 to 3.7 percent lower in the cities in which price advertising had run than they were in the control cities. l2
ADVERTISING AND INFORMATION
More recently, economists have recognized that there are differences in the information conveyed by different types of advertising. Some advertising conveys "hard" information about product prices and availability. For example, newspapers often have weekly food supplements filled with supermarket ads that provide information on price and describe special products available that week. Yellow Pages Directories report the telephone number and location (and perhaps more) of businesses ready to supply a variety of consumer and business products and services. Other advertising shows products being used in particular ways to convey the idea that the products have particular qualities (for example, a soft drink being consumed after a hard game of tennis suggests that the drink is refreshing and thirst-quenching). Some advertisements, such as those for perfume and certain automobiles, seem intended to suggest that using the product will give the consumer a particular "image." Some products, like jeans and athletic shoes, advertise themselves.
Boynton, Uhl, Blake, and McCracken, An Analysis of the Impacts of Comparative Foodstore Price Reporting on Price Structures and Consumer Behavior, Purdue University Agricultural Experiment Station Research Bulletin 968 (August 1981) and McCracken, Boynton, and Blake, The Impact of Comparative Food Price Information on Consumers and Grocely Retailers: Some Preliminary Findings of a Field Experiment, 16 J . Cons. Affairs 224 ( 1 982).
Nelson has done considerabIe theoreticaI and empirical work which refines Stigler's analysis and shows that the way in which a product is advertised is determined largely by characteristics of the product. Nelson, Advertising as Infonnatioivn, 82 J. Pol. Econ. 729 (1974). Nelson notes that certain goods have qualities (often called "search" qualities) that can be established without actually buying and using the good
-- such goods are often called "search"
goods. Other goods have "experience" qualities -- their characleristics cannot be determined purely by inspection, but only after the product has been purchased and used. Clothing is a search good (the style and construction can easily be observed without purchase), while canned tuna fish is an experience good (the taste can only be determined by eating it). For search goods the consumer can verify by inspection any clainls made by the advertiser. If an advertiser claims that a brand of dress is well-made or flattering, a consumer can go to a store and verify that claim without buying the dress. Advertisers of goods with search qualities cannot gain by lying because consumers will be able to tell they are lying. An advertiser that lies will not make additional sales as a result of his advertising, and, moreover, he will reduce the credibility of future advertising. Thus, the advertiser has a clear incentive to tell the truth and provide accurate information to consumers. It is more costly for consumers to verify the truth of claims made by advertisers of that experience goods. Such verification req~lires the consumer purchase the good in question and perhaps competing goods as well (to verify, for example, that one brand of tuna tastes best, that a particular type of tire is especially safe in the rain, or that one detergent whitens better than mother).'3
Because makers of d l brands of a product have the incentive to make the same
Critics sometimes argue that many advertisements "lie" because, as noted below, all advertisers have an incentive to claim their products are best and no one will acknowledge having a bad product. A number of institutional and market factors help insure that most advertising is truthfill1. First, truth-in-advertising laws (e.g., the Lanham Act) prohibit fims from disseminating intentionally inaccurate or misleading infomation. (Moreover, these laws and regi;!ations appea- to be effective. For example, Sauer and Leffler find that the FTC's Advertising Substantiation Program, developed in the early 1970s, succeeded in promoting more credible advertising. Sauer & Leffler, Did the Federal Trade Co~nmission'sAdvertising Szrbstantiation Program Promote More Credible Advertising?, 80 Am. Econ. Rev. 191 (1990).)
claims, consumers cannot believe in the direct advertising messages for experience goods -- no
however, that it is not the content of the advertising message, but the fact that a seller chooses to advertise that provides information about products with experience qualities, i.e., the mere fact that the advertising exists signals that the advertiser believes his product is a "good buy" and thus worth advertising. Advertisers whose products provide more value per unit expenditure, either because they are superior or because they are produced more efficiently, can win customers who will buy that brand repeatedly even though the cost of advertising is reflected in the product's price. Furthermore, advertising increases the probability that consumers will remember the brand name. Thus, those brands of experience goods most likely to appeal to consumers (i.e., those brands with the highest probabilities that consumers will like them and therefore make repeat purchases) have the greatest payoff from advertising. In other words, advertising will have the largest payoff for those products that consumers like best. Nelson argues further that advertising of search and experience goods will differ by media and fi-equency. Advertising of search goods will tend to appear in print media because consumers of such goods are more likely to spend time voluntarily to find such information. Advertising of experience goods is more likely to appear on television or radio, or to be given a larger, flashier display in a magazine or newspaper. The reason is simple: on its face, advertising of experience goods does not appear to deliver any information of value to consumers; therefore, consumers
(Footnote Continued) 2. Competition among advertisers in the form of rivalry in claims alerts consumers to the possibility of error. Thus, if a consumer views advertisements for three competing brands of detergent, each of which claims t o "whiten brightest," he is unlikely to have much faith in claims of that sort. 3. Firms have a financial incentive to preserve their reputations. Consumers who buy a product on the strength of advertised claims that turn out to be false are unlikely to believe that advertiser's claims again. The incentive for an advertiser to avoid false claims will depend on the importance of repeat sales of the advertised product, as well as on the expected initial and repeat sales of other products made by the same fm,including those that will be introduced in the future and that the firm will hope to induce consumers to try through advertising.
otice the information if it does not require much effort on their part, if it appears, for example, in the middle of a television show or in a particularly eye-catcl~ingprint display. In addition, experience goods are advertised more frequently in order to increase the probability consumers will remember the brand's name. Nelson tests and confirms these
propositions with data on advertising expenditures and amounts.
A further implication of Nelson's work is that advertjsements consisting of flashy
endorsements by celebrities with no particular knowledge of the product (whch might be construed by critics as "wasteful" because they are intended not to provide "hard" information but only to create an "image") are in fact aimed at bringing new products to a consumer's attention in a way that they will remember when they shop for the product. For example, as one study states: a nontrivial amount of advertising (especially on television) has little or no obvious informational content. A relatively recent example is the ad that w a s shown when Diet [Coke] was introduced: a large concert hall full of people, a long chorus line kicking, a remarkable number of (high-priced) celebrities over whom the camera pans, and a simple announcement that Diet Coke is the reason for this assemblage. Milgrom & Roberts, Price and Advertising Signals o Product Qualily, 94 J. Pol. Econ. 796 f
The quality the Coca-Cola Company presumably wanted to convey -- that Diet Coke tastes good -- is impossible to convey directly in an advertisement. Instead, the Diet Coke
m advertising conveys the important information that Coca-Cola, a f with a reputation for softdrinks that taste good, has introduced a new diet cola. Because the advertisement is flashy, people are more likely to notice it and seek out the product when they shop than they would be if the screen had been filled instead with black and white copy. Even though it contains no "hard" information, the advertisement benefits consumers by bringing to their attention the news that a new product they may enjoy has been introduced.14
p p p p p
Indeed, the advertising itself may be a form of entertainment, e.g:, Michael Jackson's commercials for Pepsi, and thus may offer direct consumer benefit. (Footnote Continued)
EXTERNAL BENEFITS AND THE INCENTIVE TO ADVERTISE
Not all information conveyed by one firm's advertising benefits only that fm. In many cases, advertising, particularly by a firm with an entirely new product, provides information that benefits all firms in the industry, including future entrants. For example, Amana's initial
advertising of its pioneering microwave oven provided consumers with information on how such ovens work, what they can do, etc. This created consumer demand for the product, which benefited subsequent entrants, such as Litton and Panasonic. Advertising by these later entrants was used to explain the benefits of their particular brands rather than to expIain to consumers the functions of a microwave oven; Amana's advertising had already provided general product information and helped create consumer demand for the product. In short, Amana was unable to capture all the benefits of its own advertising.15 Another example of advertising which benefits competitors, as well as the advertiser, is the 1975 campaign for the Datril brand of acetaminophen, a relatively new over-the-counter drug. That campaign was based on price comparisons to Tylenol, the largest selling (but largely unknown) brand of acetaminophen. Original ads claimed that Datril was chemically identical to Tylenol but sold for one dollar less. Within months after Datril was launched nationally with advertising and promotional expenditures of nearly $1 million a month, Tylenol reduced its price to meet Datril's; Tylenol's sales increased dramatically; and Tylenol's share of sales of all analgesics (aspirin included) increased by more than a third. In contrast, Datril managed to
capture only a two percent share. The Datril advertising increased consumer awareness of the
This phenomenon is even more pronounced in industries in which there are "external" benefits to the product itself. For example, if one examines "networked" products like FAX machines, advertising that gets a person to buy a FAX machine will benefit not only the seller of the machine, but existing owners of FAX machines. In such a case, the advertiser captures even less of the total benefit of his advertising than he does in the more typical scenario.
benefits of acetaminophen relative to aspirin-based analgesics, but Datril's attempt to compare itself favorably with Tylenol simply increased consumer interest in Tylenol. By the winter of 1976, Tylenol was the largest selling analgesic in the United States "and was well on its way to becoming the biggest-selling health and beauty product in the nation -- most of the growth owing to advertising, and much of it owing to someone else's advertising."" M m & Plurnmer, The Big
Headacl~e, Atlantic Monthly 39 (Oct. 1988).
As these examples show, advertising gives consumers information. Thus, it often
promotes not only the fm that does the advertising, but the industry in which that fm participates as well. This can have substantial benefits to society, particularly in the case of new products. On the other hand, it may also mean that the advertiser can capture only a portion of the total benefit and thus will have too little incentive from the viewpoint of society to engage in advertising. In such cases, one must be particularly careful about a tax that would increase the costs of advertising and thereby further discourage firms from providing it.
ADJ/ERTISING AND MARKET ENTRY
As we discussed in the introduction, the early hostility to advertising arose in part fiom the belief that advertising was synonymous with the absence of competition.17 Recent economic literature, however, has shown that advertising generally promotes entry and expansion by enabling new or small firms to inform consumers efficiently about their products. For example, a study by Lynk found that television reduced the real cost of advertising, provided consumers with more information, and had a procompetitive and deconcentrating effect in a number of industries. Lynk, Information, Advertising, and the Stnicture of the Market, 54 J. Bus. 271
There is yet :nether exariiple in the soft-dikk indusiiy: 'Wnen Pepsi introduced Siice soda, saies of Iemonlime soft drinks surged by 70 percent. See, "Tuning Out TV Ads," Newsweek 42,43 (Apr. 17, 1989). See, e.g., J . Bain, Barriers to New Competition: Their Character and Conseqztences in Manufacturing, 114 ( I 956). We present an outline of the principal arguments underlying this hostility and a list of citations in Appendix B.
icular, Lynk found that in industries where a relatively larger shift of advertising to television occurred, the size dispersion of firms narrowed, i.e.: [a]n increase in the real volume of advertising messages causes an increase in the sales of smaller sellers relative to the sales of larger sellers . . . The conclusion is therefore that, in response to additional advertising, consumers readjust their patterns of purchase and, on balance, shift their patronage from larger, widely known brands and firms to smaller, preferred but previously unknown, sellers.18 Lynk, id. at 301-02. f Gomes made a similar finding. Gomes, The Competitive and Anticon-ipetitive Theories o Advertising: An Empirical Analysis, 18 Applied Econ. 599 (1 986). He tested two competing theories of advertising's effect on entry: (1) the "anticompetitive" theory that advertising increases barriers to entry by increasing capital requirements and increasing consumer loyalty to existing brands and (2) the competitive theory that advertising promotes competition because it "erodes brand loyalties, reduces consumer's search costs for products, and thereby is a means for growth of small f m s and entry of new firms." Id. at 602. His evidence supports the
competitive theory of advertising -- "advertising provides information about products, prices and sellers." Hirschey examines the relationship between advertising and entry and finds that between 1963 and 1972 advertising facilitated entry.19 Hirschey concludes that his findings support the contention that "advertising may be used to upset established market positions." Hirschey,
supra, 11.13, at 29.- Kessides finds some evidence that advertising expenditures constitute a sunk (i.e., irreversible) cost, but finds that "by providing information about the existence of alternative
The Lynk study focuses on the effects of the advent of television on concentration in various industries. Although technically he examines the sh$ of advertising into television, in fact, he uses this variable as a proxy for the overall increase in advertising messages that occurred as a result of the introduction of television. Hirschey also examined data for an earlier period but found no significant effect. Eckard also finds that changes in industry concentration levels between 1963 and 1982 are unrelated to industry advertising levels. Eckard, Advertising, Competition, and Market Share Stability, 60 J . Bus. 539.
Balriers to Entr-y,68 Rev. Econ. Stat 84 (1986). On net, his empirical study shows that "for the
2 majority of the industries examined [ 16 out of 2621, the overall impact of advertising on entry is
positive, that is, advertising actually facilitates entry [of new finns and new products]." Id. at 93. Finally, Eckard finds that prices rose less and output increased more between 1963 and 1977 in those industries which utilized television advertising than those that did not. He
concludes "The evidence provides stronger support for the view that advertising is procompetitive and that it has beneficial consumer welfare effects; i-e., it is associated with lower prices and greater output. Thus, increased market power is not the explanation for (or
consequence of) previously reported correlations between advertising levels and rising concentration." Eckard, Advertising, Concenb-ation Changes, and Consumer Welfare, 70 Rev. Econ. & Stat. 340 (1988) at 343.
In short, although some early studies viewed advertising with hostility because of the
positive correlation between advertising, concentration and profitability, more recent studies have pointed out that a positive correlation between advertising intensity and profitability is consistent with the theory, implied by Nelson, that f m s with good products tend to advertise them in order to inform consumers. Consumers respond by sampling those products and then buying them repeatedly, and thereby reward firms that have good products with greater sales and profits.
One of the goals of the 1986 Tax Reform Act was to "level the playing field," i.e., to ensure that all types of business investment are taxed equally. By definition, a corporation is investing whenever it gives up current sales (or profits) in the hope of increasing future sales (or profits). Spending on new plant and equipment is perhaps the most obvious, but not the only,
fornl of investment.
Other expenditures -- such as spending on research to develop new
in greater future profitability. Under the current tax law, an "investment" in physical assets, such as new plant and equipment, is depreciated and hence deducted from income over a number of years. Spending on "intangibles," such as R&D, employee training costs, and advertising, is generally treated as an ordinary business expense and hence deducted from income in the year in which it occurs. Proponents of a change in the tax treatment of advertising (and perhaps of other intangibles such as R&D as well) argue that if advertising has a "long" economic life (i-e., longer than one year), a
tax rule that allows it to be expensed will result in a bias in favor of investment in intangible,
rather than tangible capital.20 Thus, much of the debate over changing the tax treatment of advertising centers on whether the effects of advertising are truly long-lived. A casual examination of a variety of advertising suggests that the information it provides on the identity and location of sellers and buyers and their products and prices is of highly variable duration. Some advertising may have a long life -- a lawyer announces he is opening a law office or a grocery chain announces the opening of a new store.21 Other advertising appears to be very short-lived; for example, food supplements in newspapers list sale prices in effect for one week only and will have little influence beyond that week. Furthermore, a number of factors appear to influence the duration of advertising's effectiveness. GM's advertising might be
See, e.g., Testimony of Martin Feldstein before the Committee on Ways and Means, Congress of the United states (Jan. 31, 1989) in which he mentions the potential bias but suggests a "cash flow" treatment in which all investments are expensed. See also, Fullerton and Lyon, Tax N e u t r a l i ~and Intangible Capital, NBER Working Paper No. 2430 (Nov. 1987). Note, however, that although the person placing the ad may intend that it will have a long life, reality may be very different. The intent of the makers of New Coke and the Edsel, as well as the lawyer in this example, may have been to produce advertisements with "long-term" impact, but that may not be what actually happened. Many factors, including the receiver's memory and his interest in the product, play a role, as does the amount of competing information to which the receiver is subject. Moreover, even advertising messages that remain in consumers' memories for a very long time do not lead to continuing sales. A recent attempt to reintroduce Ipana brand toothpaste failed, despite "pangs of nostalgia of the memory of Bucky Beaver, Ipana's spokesrodent". See, "No Brand Like an Old Brand," Forbes, 179, 180 (June 11, 1990). Thus, unlike plant and equipment where a life of more than one year is a near certainty, the lifetime of an advertisement is highly uncertain even though it may appear at its inception to be relatively long-lived.
longer-lived if Ford did not advertise or if Ford advertised less. For some products, such as automobiles, advertising may increase sales of current model cars, but at the year's models. In this case, advertising would actually have a negative effect on future sales. The extent to which advertising is short-lived or long-lived is largely an empirical question.22 We have surveyed a number of daily newspapers as a simple way to get an idea of the distribution of the duration of advertising's effectiveness. Using what are, by necessity, somewhat subjective evahative criteria, we classified the space given to newspaper advertising by type (i.e., informational, price, image, etc.) and by duration of effectiveness (i.e., whether its message was obviously short-lived or not).23 Newspapers surveyed include the daily and Sunday Chicago Tribune, the daily San Francisco Chronicle, the Sunday San Francisco Examiner, and the daily and Sunday Oregonian (Portland, Oregon), all of which were published in January and February of 1989.
We find that advertising (including classified) accounts for a large fraction of the
newspaper space, 43 to 85 percent depending on the paper and the day of the week.24 Much of this advertising conveys price information. In fact, nearly 70 percent of the non-classified advertising in the newspapers we surveyed contained some price information, while almost half (on average) advertised price only. Moreover, the bulk of the advertising (whether it contains information about price or not) provides information that has an effective life of a week or less. Thus, our simple analysis suggests that most, if not all, advertising is short-lived. (For a detailed presentation of our results, see Tables C. 1 through C. 3 in Appendix C.)
This question is difficult to answer with any precision. A number of economists have studied the issue intensively and have come to widely divergent conclusions. We discuss these formai studies in Part 111. A below. An advertising message was classified as short-lived if it had an identifiable (and short) period of time during which the infomation would be usehl. Examples of such short-!ived advertising include dvertisemmts for the weekly grocery specials, advertisements for sales, advertisements for special events, etc. If we exclude classified advertising (which is inherently short-lived), then advertising space accounts for 22 to 57 percent (by square inch) of the content of the newspapers we surveyed.
Over the past three decades, there have been many empirical studies of the durability of advertising. Some suggest that the effects of advertising are relatively short-lived; others suggest that the effects last for many years. We have examined the major studies fi-om this body of literature and find that they generally suffer from various conceptual and technical flaws that render their conclusions meaningless. Our review of the literature points out how very difficult it is to obtain any general measure of the durability of advertising. In part, this is probably due to the fact that advertising is an extremely heterogeneous product and thus is not easily measured; and in part, it is probably due to the fact that economists do not yet have a good testable model of the way in which advertising affects sales. Whatever the reason, we do not believe that existing economic evidence supports the proposed change in the tax treatment of advertising.
There have been many economic studies of the durability of advertising performed over the past two or three decades.25 Several of the early studies are summarized in a survey article f f by Clarke. See, Clarke, Econometric Measurement o the Duration o Advertising Eflect on Sales, 13 J. Mktg. Res. 345 (1976). According to Clarke, the studies he surveyed found a wide range of depreciation rates for advertising, some very short (e-g., 90 percent of the advertising's effectiveness was spent within two months) and some very long (e-g., 90 percent was spent over a period of several years). The length of time it takes for 90 percent of the effect of advertising to disappear is called the "90 percent duration interval."26 Upon closer examination, Clarke found that the length of the estimated 90 percent duration interval was closely correlated with the periodicity of the data used in the particular
These studies all rely on a statistical technique called regression analysis. This technique is explained in some detail in Appendix E. I. Typically, the existing studies estimate a coefficient that allows one to calculate the depreciation rate of advertising directly. One can then manipulate this rate to determine the interval over which a specified fraction (say 90 per cent) of the effect will last.
econometric study. Those studies that used weekly or monthly data generally found that the
advertising expenditures appeared to still influence sales for several years after the advertising appeared. (See Table 4, which reproduces Clarke's Table I .) Based on his investigation, Clarke concluded that studies using annuaI data are not reliable because they are plagued by "data interval bias," a statistical problem encountered when the periodicity of the data exceeds the duration of most of the effect g i g measured.27 Studies that used monthly, bimonthly, or quarterly data are less likely to be affected by data interval bias and thus are likely to be more reliable. These studies show that "the duration of cumulative advertising effect on sales is between 3 and 15 months; thus this effect is a short-term (about a year or less) phenomenon." Clarke, supm at 355. There has been a fair amount of additional work since Clarke's survey was published, and again, the results have been mixed. (See Table 5 for a summary.) Many of these studies (as well as most of those Clarke surveyed) use the Koyclc lag model, which examines today's sales as a function of advertising undertaken in the current and previous periods.28 This approach models this period's sales as a function of last period's sales and this period's advertising. coefficient on advertising measures the benefit of cu~rentadvertising on cun-ent sales. The The
In simple terms, data interval bias will lead to distorted results when one is trying to measure an effect that lasts a month with data that cover an entire year. The mathematical notation for this model is St = go + gl St-] + g2At + Et, where S = Sales and A = Advertising Expenditures. This is derived from the model
where a simple polynomial lag structure is assumed.
coefficient on last period's sales measures the "carry-over" effect 0f advertising in prior periods; this coefficient is used to calculate the decay rate or the rate of depreciation of the effects of
Four recent studies that use the Koyck lag model are summarized below:
In a study of consumer products, Abdel-Khalik found annual decay rates of 18 to
24 percent for food and about 15 percent for drugs and cosmetics, but could not obtain meaningful results for three other products he studied (soap and cleansers, tobacco, and automobiles). He concluded that only food and drugs "showed some evidence of distributed [i.e., long-term] effects of promotion on sales." Abdel-Khalik, Advertising Effectiveness and
Accountii7g Policy, 50 Acctg. Rev. 657, 662 (1975).
2. Picconi extended the Koyck lag model to examine the effect of competitors'
advertising on a firm's sales for six brands of soft drinks. He found &at there was "no significant correlation . . . between advertising expenditures and increased futwe benefits as measured by subsequent sales," but that there was evidence that advertising influenced current sales share for two of the six brands. He found 90 percent duration intervals of between 2 and 22 months and concluded that his study "creates uncertainty about which advertising expenditures will have asset quality and which will not at the period that the advertising cost is incurred."30 Picconi, A
Reconsideration of the Recognition ofAdvertising Assets, 15 J . Acctg. Res. 317,323 (1 977).
3. Falk and Miller used a model under which they estimated directly the duration of
advertising for divisions of domestic automobile companies and distributors of foreign automobiles. Their results suggest that the effects of advertising are generally short-lived: they studied the advertising of twenty-five separate entities and found that there were only two for
These studies analyze annual data and still suffer from interval bias. A recent article suggests methods which, under certain assumptions, permits correction for interval bias. See, Rao, Estin~atingContinuous Time Advertising-Sales Models, 5 Mktg. Sci. 125 (1986). None of the studies reviewed here has made such a correction. This particular finding is directly relevant to implementing any proposal to tax advertising as an investment.
f which the effects lasted as long as five quarters. Falk & Miller, Amortization o Advertising Expenditurw, 15 J. Acctg. Res. 12 (1977). 4. Thomas extended the Koyck lag model to include "brand quality" and found that it
is "brand quality," not advertising, that creates intangible capital. He also found that for the two products he studied (cigarettes and soft drinks) the effects of advertising are short-lived, i.e., the 90 percent duration interval is less than one year. Thomas, Advertising in Consumer Goods Industries: Durability, Econonzies ofscale, and Heterogeneity, 32 J. Law & Econ. 163 ( I 989). Although easy to implement, the Koyck lag model faces serious conceptual and empirical problems.3' Some econonlists have attempted to avoid these problems by examining whether advertising creates intangible capital.3"The basic idea is the following: if advertising does, in
fact, create intangible capital, then the effects of advertising must last for more than one year.) Some of these studies have concluded that advertising is durable (i-e., that it creates capital value), while other more recent studies have found the opposite: 1. Ayanian, Bloch, Hirschey, and Hirschey & Weygandt examined the durability of
advertising for a number of different industries and all found that advertising is relatively longlived. In fact, Bloch found that advertising capital depreciates at the rate of 5 percent per year. Ayanian, The Advertising Capital Controver-sy, 56 J. Bus. 349 (1983); Bloch, Advertising and f Profitability: A Reappraisal, 82 J. Pol. Econ. 267 (1974); Hirschey, Intangible Capital Aspects o Advertising and R&D Expenditul-es, 30 J. Ind. Econ. 375 (1982); and Hirschey & Weygandt, Anfortization Policy for Advertising and Research and Developnzent Expenditur-es, 23 J. Acctg. Res. 326 (1985). 2. A more recent article finds that advertising is not durable. Bublitz and Ettredge
examined various publicly traded companies, divided into producers of durable goods and producers of non-durable goods, and found that advertising does not create intangible capital or,
See, discussion, infia at 4 1.
In several studies, particularly those by Hirschey, intangible capital is measured as the difference between the firm's market and book (or replacement) values. This derivation is discussed in detail below in Part 111. C.
equivalently, that the effects of advertising last for less than one year. Bublitz & Ettredge, The
Existing studies arrive at such different conclusions about the durability of advertising that we do not believe they can be used as a basis for formulating tax policy. Many articles, particularly the recent ones, suggest that advertising is short-lived and should be expensed; others suggest it is long-lived and should be amortized over periods as long as hundreds of years. Moreover, estimates of economic depreciation rates differ substantially across industries and even among f m s within the same industry. This diversity may be due in large part to serious technical flaws in the economic models that underlie many of these studies. But, in any event, the existing economics literature provides no reliable evidence to support the notion that advertising is long-lived.
Most previous economic studies use the Koyck lag regression model to measure the durability of advertising. As already noted above, the coefficient on past period sales, whch measures advertising's "carry-over" effect, can be manipulated to yield an estimate of the depreciation rate of advertising capital. Rao, supra, 11-28 at 36. More recent work, led by Mark
Hirschey, has suggested investigating the relationship between firms intangible capital and advertising as an alternate method for determining depreciation rates. In this section, we discuss some of the technical flaws in the existing studies and in light of these flaws, we examine the validity of the findings based on each of these methods.
The empirical findings based on the Koyck lag model suffer from several fkdamental flaws. First, the model utilized by most researchers is based on an underlying unsupported assumption that all investments in "good-will" depreciate at a common and constant rate over time.33 Thus, expenditures on advertising that convey very short-lived information, such as announcements of sale prices, are treated as if they have the same effect on sales in the hture as do expenditures on advertising that may impart information, such as that concerning product quality, with a potentially longer life. Furthermore, since the coefficient on lagged sales reflects the durability of
all investments in good-will and
other intangible assets (e.g., R&D or worker
training), the procedure cannot identify whether advertising has any long lasting effects at all; it merely assumes that all long lasting effects are due to advertising. Thus, expenditures on advertising by the procedure are assumed, or even "forced" to have the same useful life as other expenditures which may truly have long lasting effects, such as those on R&D or worker training. Second, for purely statistical reasons, estimates of durability derived fi-om Koyck lag models typically tend to overstate the true length of advertising's effectiveness for two reasons:
Advertising and sales both occur continuously, rather than in discrete intervals. But
empirical work is based by necessity on data gathered over discrete time intervals (e.g., months, quarters, years, etc.). Unless one pays careful attention to the "temporal aggregation" problem, analysis of discrete time data may lead to overestimated durability. (See earlier discussion of interval bias, supra at 34.)
Many empirical investigations of advertising have examined pooled time-series data
for several firms or industries. This procedure assumes implicitly that a f m ' s sales are affected
The nature of the statistical models used does not permit one to estimate different depreciation rates or useful lives for different kinds of advertising or, for that matter, for other forms of investment in good-will or hture earning power, like research and development.
only by its own ad~ertising.3~ there are many factors (other than its own advertising) that But may affect a firm's sales -- for example, advertising by rivals and changes in the product. If these factors are not taken into account, the regression coefficients will be biased.35 In fact, if (as seems likely here) the omitted factors are positively correlated with both sales and the productivity of advertising, this bias will lead one to conclude that advertising has a longer life than is indeed the case. To see how this problem arises, assume that advertising increases sales in the first period only; therefore, the true annual depreciation rate for advertising is 100 percent. Now assume that firms with large sales (because they have a better or more innovative product) also advertise more (since advertising a better product is more productive, in terms of increased future sales and profits, than advertising a poorer product). A regression that pools data from many f m s will find (I) that higher advertising is associated with higher sales in both the current period and the past period and (2) that the coefficient on lagged sales is close to one. This translates into an estimated depreciation rate for advertising that is close to zero. A regression that pools data for many firms will lead to an underestimate of the true depreciation rate (i.e., it will significantly overstate the durability of advertising). The problem arises from "omitted variable bias." (See Figure 1 for an illustration of how such bias may affect estimated coefficients.) This bias can be very large, and when it is, the durability of advertising will be grossly over-estimated.36 In other words, many estimated depreciation rates previously reported in the economics literature are biased because there is substantial correlation across firms between sales and advertising, even for firms in the same industry. In short, the Koyck lag model, the statistical
Among recent studies, see, e.g., Bloch, supra, at 39 and Ayanian, supra, at 39 who find advertising to be relatively long-lived. Technically, this problem is called "omitted variable bias." Thomas' article takes into account "brandspecific" factors ("brand quality") and is thus fiee from this bias. He finds advertising to be short-lived. Thomas, supra, at 38. We have performed our own empirical analysis to illustrate the magnitude of this bias. presented in detail in Appendix D. This analysis is
stimates of the useful life of advertising are most commonly based, leads to overestimates of that life when data for more than one firm are pooled.
In two papers published in the early 1980s, Mark Hirschey proposes examining the
relationship between a firm's intangible capital and its advertising as another means for estimating the useful life of expenditures on advertising.37 Proponents of the proposed change in the tax treatment of advertising, particularly George Mundstock, cite Hirschey's work to support the premise that advertising is long-lived capital. Mundstock, Taxation o Business Intangible f Capital, 135 U. Pa. L. Rev. I 179 (1 987). In the more recent paper, co-authored with Jerry Weygandt, Hirschey examines the relationship between the ratio of the market value of a firm's assets to an estimate of the replacement cost for those assets' (sometimes called Tobin's "Q") and the f m ' s advertising-to-sales ratio.38 Hirschey's hypothesis is that the firm's market value reflects all the intangible factors that have systematic effects on its future profitabiIity. Thus,
whatever value advertising has in creating intangible assets should be reflected in the ratio of the market value to the replacement value of the firm's assets. Hirschey and Weygandt's findings appear to support the view that advertising is an investment in intangible capital: the coefficient on the advertising-to-sales ratio is positive and statistically significant, which means that in their sample of firms a higher advertising-to-sales ratio is accompanied by a greater ratio of market value to replacement value of the f m ' s assets. This suggests that current advertising generates future returns. Hirschey and Weygandt combine the estimated coefficient on the advertising-to-sales ratio with measures of the growth in
The ratio of the market value of a firm's assets to an estimate of the replacement cost for those assets' ii~ (sometimes called Tobin's "Q") See Tobin, Ivionefmy Policies and ihe E c o i ~ ~ The T i . i l i ? ~ l i i i ~ ~ i ~ i ? Mechanism, 37 Southern Econ. J. 421 (1978).
The market value of the firm's assets is measured by the market value of its common stock plus book value of its debt (including preferred stock, if any).
advertising expenditures over time to estimate the depreciation rate of advertising capital. Their results suggest that advertising depreciates between 10 and 20 percent per year in the nondurable goods sector and between 30 and 60 percent in the durable goods sector, or, alternatively, that the 90 percent duration intervals are between 9 and 20 years in the non-durable goods section and between 1.5 and 5 years in the durable goods section.
Theoretical Flaws in Hirschey and Weygandt's Model
Hirschey and Weygandt's model suffers fiom a serious theoretical problem. In order to assure a direct relationship at any point in time between flow of advertising and the unobservable stock (or advertising capital) of the firm, Hirschey and Weygandt must assume that all firms are in a steady state, i.e., that both the growth rate of advertising expenditures and the depreciation rate of advertising remain constant from year to year.39 Without this critical assumption, the model would not yield unambiguous implications about the durability of advertising. Under the steady-state assumption, the capital value of advertising is a constant multiple of current expenditures on advertising and depends only on the (assumed) constant rates of advertising growth and depreciation:
IC = Al(a + y),
where IC and A stand for the intangible capital value of advertising and advertising expenditures, respectively, and a and y measure the advertising depreciation and growth rates, respectively.40 Hirschey and Weygandt use this relationshp to infer firm-specific depreciation rates:
This allows them to use the observable annual expenditures on advertising as a proxy for the unobservable stock of advertising capital possessed by the finn. As we show below, the assumption is incorrect. It is, however, a mathematical construct that is necessary to the model Hirschey and Weygandt use. Since Huschey and Weygandt model the problem in discrete time, the proportionality factor between advertising and intangible capital they use is somewhat different from the one we use in (1) above, which results from a model in continuous time. This difference does not in any way underlie or affect our criticism of their method.
efficient~] obtained through analysis of an underlying econometric model , [depreciation rates] become readily available. Id. at 332. Thus, Hirschey and Weygandt compute a five-year historical growth rate in advertising expenditures for each firm in their sample and equate the resulting number with y above. Then, they set the expression in (1) equal to the estimated regression coefficient on the advertising-tosales ratio, and impute a depreciation rate for each firm. This approach to estimating depreciation rates has a serious internal inconsistency. Although both the growth rate and the depreciation rate of advertising are assumed to vary across firms, the sun1 of the two rates is (by definition) the same for all firms.41 In Hirschey and Weygandt's model, this assumption is required in order for differences in advertising expenditures among firms at any point to reflect differences in the intangible capital "created" by advertising. However, the assumption forces an inverse relationship between growth rates and depreciation rates, so that firms with high growth rates in advertising expenditures necessarily have low estimated depreciation rates and firnls with low growth rates necessarily have high estimated depreciation rates. This restriction, which has no basis in theory, clearly renders n7eaningles.s depreciation rates estimated using the Hirschey and Weygandt methodology.
In our terminology, a + y = C, where C is any positivexonstant. T_n Hirschey and Weygandt's paper, which assumes discrete time, (1 + y) = K (a + y) where K is a positive constant that exceeds unity. (A value of K less than unity implies a > I , or full depreciation within a year, and is inconsistent with the notion of intangible advertising capital.)
Empirical Flaws in Hirschey and Weygandt's Modd
In addition, Hirschey and Weygandt's study is affected by two empirical flaws: 1. As already noted, the steady-state assumption implies that advertising capital is a constant multiple of advertising expenditures at any point in time. This assumption implies that regressions of Tobin's Q on the advertising-to-sales ratio for different time periods should yield the same coefficient estimates and the same estimated depreciation rates. We test the steadystate assumption below and find that it is not supported. We do not have access to Hirschey and Weygandt's data. However, we are able to test the underlying steady-state assumptions by applying their methodology to a sample of over 500 f m s for which data are available from Compustat Data S e r ~ i c e s . ~ ~ run regressions similar to We Hirschey and Weygandt's for ten years.43 (See Table 6.) These results c o n f i that the coefficient on the advertising to sales ratio is not stable, but varies substantially over time.44 The coefficient is positive and significant in only three of the ten years (a result that, we find, derives
The sales and advertising data are reported by Standard & Poor's Cornpustat Data Services, Inc. We estimate the model by industry, using CompuStat7sinformation on each h ' s two-digit SIC classification. See Appendix E. I1 for a full set of regression results and Appendix E.111 for a listing of the data that underlie them. Appendix E is not printed with this document but is available upon request. One difference between Hirschey and Weygandt's regression and ours is that our sales-growth variable measures growth in the coming year, whereas theirs measures historical sales growth. Since market valuations are forward looking, our specification is preferred. Their work also treats R&D expenditures, like advertising expenditures, as investment in intangible capital. We include the ratio of R&D to sales as an explanatory variable in our regression equation, but do not compare our findings about R&D with theirs except to note that the coefficient on R&D also varies over time and appears to be affected by omitted variable bias. Finally, Hirschey and Weygandt include a measure of the four-firm industry concentration ratio in the regression to capture the effect of industry structure. We include individual dummy variables for each of the 26 industries in our sample. Indeed, our results do not show the positive association between advertisirng and Tobin's Q that Hirschey and Weygandt found in 1977. This may result from our slightly different specification (see n.41 above) or fiom differences in our sample of firms for that year. In either case, it is clear that Hirschey and Weygandt's results are not robust. In an investigation of the relationship between industry structure and mobility barriers, Lustgarten and Thomadakis also ran a variant of Hirschey's model for varying time periods between 1964 and 1978. They found that the coefficients on advertising, R&D and concentration varied substantially over time. Thus, they conclude that "the use of Tobin's Q in industrial organizations studies must take account of the role of investor expectations. Estimations arrived at in a pnrticular time period mqy not be valid in another. . .." [Emphasis added.] Lustgarten & Thomadakis, Mobility Barriers and Tobin's Q, 60 J. Bus. 519 (I 987).
to its standard error) differs considerably among the years. This fmding has two important implications. First, it is inconsistent with the steady-state assumption that is critical to Hirschey and Weygandt's model. Second, the varying coefficients imply depreciation rates that vary dramatically over time and thus call into question the validity of any depreciation rates estimated using this method at any one point in time.
The spurious relationship between sales and advertising discussed above in relation
to the Koyck lag estimation technique is perhaps even more important here. Clearly, there are many economic factors other than advertising that determine the market value of a fm. Most important is the value of the firm's product in the market place. Indeed, the value of the firm's product -- e.g., its effectiveness or innovativeness
-- is the firm's true intangible asset.
Advertising is only a means by which the firm can exploit fully the value o f that asset. A simple example helps to illustrate this point. Apple Computer developed an
innovative user interface, the "Finder," which it provides on its Apple Macintosh personal computer. The interface has been enormously popular and Apple has exploited its value by advertising its advantages to potential users. As a result of the success of this product, Apple's sales have soared as has its market value. But Apple's advertising is not the intangible here; it is only a tool for maximizing the value of the true intangible -- the interface. After the Apple interface entered the market, Microsoft developed software for use on the IBM PC that duplicates many of the Macintosh desktop characteristics. Apple's extensive and costly litigation with Microsoft (and others) to protect its exclusive right to the interface reflects the fact that this right is a valuable intangible asset. When Apple won the first round of this litigation against Microsoft last year, Microsoftys market value fell by 9 percent, or $257 million.45 Moreover, if Apple were ultimately to lose its exclusive right to the interface, its market value (and thus its Tobin's Q) would fall dramatically as a result.
This valuation is based on the fall in Microsoft's stock price between March 15, 1989 and March 17, 1989.
Similar examples could be drawn for other firms. The point is simple: firms with better products are more likely both to advertise and to have replacement value of assets; the relatively high market value reflects the expected future sales of the product. See, e.g., Nelson, supra, at 19. Therefore, in Hirschey's model a spurious
correlation between advertising and the market value of the firm will exist, because important variables (other than advertising expenditures) that lead to systematic differences among firms are omitted from the regression. We attempt to illustrate the magnitude of the omitted variable problem overlooked by Hirschey and Weygandt by pooling all available data for the years 1983 to 1986 for the five hundred f m s in our sample and including individual firm-specific dummy variables in the The regression eq~ation.~6 individual firm dummies capture differences in the Q-ratios across f m s that are unrelated to differences in their advertising expenditures. Thus, with this
adjustment the coefficient on the advertising-to-sales ratio should not be biased by spurious correlation. When firm-specific efforts are omitted from the analysis, the coeficient on the advertising-to-sales ratio is statistically significant and is within the range of the estimated coefficients presented for the years 1983 to 1986 in Table 6. Including the individual firmspecific dummies (thus eliminating the problem of spurious correlation arising from omitted variables) results in a coefficient on the advertising to sales ratio that is both small and statistically indistinguishable from zero. Thus, when we control for spurious correlation arising from omitted variables, the analysis provides no evidence that advertising has capital value that survives beyond the immediate period. In fact, if we used the Hirschey and Weygandt method to derive depreciation rates fiom the estimated coefficient on the advertising-to-sales ratio (despite our belief that it yields
It is only during this period that advertising and Q appear positively related. (See Table 6 . ) If we pool the data for all ten years, the relationship disappears.
meaningless estimates of depreciation rates), we would find that the implied annual depreciation rates are very high and the implied 90 percent duration intervals are very low: less than six months for each of the 26 industries we analyze. Thus, when corrected for the spurious
correlation that arises fi-om omitted variables, the Hirschey and Weygandt method shows that advertising is rather short-lived. This fact seriously erodes the empirical foundation on which the conclusion that advertising is long-lived rests.
W H A T LESSONS CAN WE DRA FROM THIS? W
Our examination of the various studies calls into question much of the work that has been done on advertising durability and decay rates. Although the results of these studies are mnixe4 many of them suggest that the effects of advertising are very long-lived. These studies, however, generally suffer from a variety of flaws that render their results unreliable. Many of these flaws are the result of technical errors that tend to bias the estimates of the durability of advertising upward. If these technical flaws were corrected, we would find that the estimates of the life of advertising's effectiveness would be much shorter than is suggested by this literahre. On the other hand, even if these flaws are corrected, the studies still have theoretical and conceptual problems, and thus we do not believe that correcting these flaws alone would lead to reliable estimates of advertising's durability. Our work points out how very difficult it is to obtain any general measure of the durability of advertising. In part, this is probably due to the fact that advertising is an extremely heterogeneous product and thus is not easily measured; and in part, it is probably due to the fact that economists do not yet have a good testable model of the way in which advertising affects sales. Whatever the reason, we do not believe that existing economic evidence supports the proposed change in the tax treatment of advertising.
In summary, we believe that support for the proposed change in the tax treatment of advertising is based on two mistaken views of advertising: (1) that advertising is "bad" or "wastefd" and (2) that advertising (whether it is bad or good) is inherently long-lived and therefore should be treated under the tax code as other investments with long lives. But as we have shown, advertising provides information and consequently much advertising facilitates the efficient exchange of goods and services: in other words, advertising is generally good, not bad. Second, although there are a number of economic studies that suggest that advertising is long-lived, they are generally so fraught with errors that one cannot rely on their fmdings. When we correct for some of the statistical problems, we find that estimated duration intervals are much shorter than originally thought. Moreover, there are a number of studies (particularly more recent ones) that suggest that advertising depreciates so rapidly that virtually all of its effects are gone within a year. In short, the economic evidence does not support the view that advertising is long-lived. Finally, a change in the tax treatment of advertising would yield very little in additional revenue. There are unusually good substitutes for advertising in informing buyers of the existence and qualities of a product; and a tax on advertising alone would simply induce substitution. Moreover, if the definition of advertising is broadened, revenue may be enhanced but there will surely be a greater adverse effect on the efficient dissemination of information to consumers.
Table I Breakdown of Industrial Company Marketing Costs For SIC Industries With 10 Or More Respondents Percentage of Marketing Communications Budget Spent On Industry (number in parenthesis is number of reporting comuanies) Furniture & Fixtures (10) Chemicals & Allied Products (21 -22) Fabricated Metal Products (31-33) Machinery, Except Electrical (104-106) Electronic Computing Equip. (Hardware) (16) Electrical & Electronic Equipment (53-54) Transportation Equipment (1 7) Instruments & Related Products (42-44) Overall Source: Note: 39.6 36.3% 19.9% Literature, Deals, Coupons Point-of-Purchase Dealer, Distr. Helps Public Relations & Publicity 3.1% 2.4 3.2 3.9 9.2 6.2 7.0
Exhibits & Trade Shows
Catalogs & Directories
McGraw-Hill. Laboratorv of Advertising Performance (LAP) Reoort
-- Industrial Marketing Costs #8015.7
Percentages may not sum to 100% because some respondents did not provide information on all budget items and because RadioKV/Billboard advertising was not reported on an industry basis. (The overall percentage for that category is 1.9%.)
Table 2 Total Selling, Advertising and Promotion Costs for Selected Companies 1985-1987 Total Selling and Marketing Costs (% of ($Millions) Sales) Total Advertising and Promotion Costs (% of ($Millions) Sales) Advertising & Promotion as a Percent of Total Selling and Marketing Costs
Company Ashton Tate Lotus Development Corp Management Science America
Lines of Business Computer Software Computer Software Computer Software Household and Personal Care Products; Health Care; Specialty Mar-
Kimberly Clark Personal Care Products; Newsprint & Groundwood Paper; Aircraft Maintenance & Other Misc.
Table 3 Estimated Annual U.S. Advertising (in millions of dollars)
Newspapers National Local Magazines Weeklies Women's Monthlies Farm Publications Television Three Networks Cable Networks Syndication (nat'l) Spot (nat'l) Spot (local) Cable (non-network) Radio Network Spot (nat'l) Spot (local) Yellow Pages National Local Direct Mail Business Publications Outdoor National Local Miscellaneous National Local
Graiid Totaf National Local
Source: Robert J. Coen, McCann-Erickson, Inc.
Table 4 Survey of Econometric Sales-Advertising Analysis
Coefficent of Lagged Dependent Variable A
90% Duration Interval (Months)
Nakanishi Sexton Catsup Frequently purchased grocery product
Bass and Clarke Beckwith Montgomery and Silk Palda Samuels Samuels Samuels Samuels Samuels Samuels Samuels Dietary product Low priced food Ethnical drugs Lydia Pinkham Toilet Soap Household Cleaner Household Cleaner Washing up liquid Washing up Iiquid Washing up liquid Scouring powder
Aaker and Day Aaker and Day Aaker and Day Bass and Parsons Houston and Weiss Clarke Clarke Clarke Wildt Wildt Wildt Instant coffee (mean) Instant coffee (low) Instant coffee (high) Low priced food 18 low priced food brands (high) 18 low priced food brands (low) 18 low priced food brands (low) 18 low priced food brands (mean) Frequently purchased food-firm 1 Frequently purchased food-firm 2 Frequently purchased food-firm 3
Ball & Agarwala Ball & Agarwala
Tea (low) # Tea (high) #
Table 4 Survey of Econometric Sales-Advertising Analysis (continued)
Researchers Quarterly Cont. Buzzell et al. Buzzell et al. Lambin Lambin Lambin Lambjn Lambin Larnbin Schultz Annual Larnbin Larnbin Palda Parsons & Schultz Parsons & Schultz Parsons & Schultz Parsons & Schultz Taylor & Weiserbs Lambin Lambin Lambin Lambin Simon Simon Simon Simon Simon Simon Dominguez Dominguez Telser
Coefficent of Lagged Dependent Variable A
90% Duration Interval (Months)
Toilet Soap Assorted low priced products Gasoline brand A Gasoline brand B Gasoline brand C Gasoline brand D Gasoline brand E 6 gasoline brands Airline frequency share
Frequently purchased food Frequently purchased food Lydia Pinkham Aggregate consumption Aggregate consumption (services) Aggregate consumption (non-durables) Aggregate consumption (durables) Aggregate consumption Small electric appliances - area I Small electric appliances - area 2 Small electric appliances - area 3 Gas station share Liquor 8 blends Liquor bourbon Liquor gin Liquor vodka 15 brands (low) 15 brands (high) Filter cigarettes Non-filter cigarettes Lucky Strike
Table 4 Survey of Econometric Sales-Advertising Analysis (continued)
Coefficent of Lagged Dependent Variable A
90% Duration Interval (Months)
Telser Telser Telser Telser Schnabel Schnabel Schnabel Schmallensee Schmallensee Schmallensee Peles Peles Peles Camels Camels (share) Lucky Strike (share) Chesterfield (share) 18 cigarette brands 18 cigarette brands (low) I8 cigarette brands (high) Cigarettes (industry) Cigarettes company (low) Cigarettes company (high) Automobiles Beer Cigarettes
Source: Reproduced from Clarke, Econometric Measurement of Duration of Advertising Effect on Sales, 13 J. Mktg. Res. 345, 349 (1976).
Table 5 Summary of Advertising Capital Dep Found in the Recent Literature
Sample and Product Firms among the top leading advertisers in five industries
Periodicity of Data Annual
Coefficient on lagged sales of: 0.76-0.82 (food) 0.84-0.85 (drugs & cosmetics) For other products results were not meaningful Advertising life - 6.8 to 7.9 years (implies a 12-14% annual depreciation rate)
Pooled time series, crosssectional data with im individual f r dummies; Koyck distributed lag adjusted for serial correlation; includes advertising variable. Found depreciation rate that maximized Rx in regression of accounting rate of return on advertising expenditures and growth rate of sales. Used micro-model of effect of advertising on sales to derive aggregate model with nonlinear effect of advertising on sales. Averaged 36 monthly or 18 bimonthly aggregate observations. Found depreciation rate that maximized Rx of regression of stock market value to book value of stock and profitability. Regression of cumulative abnormal returns (monthly returns cumulated over a year) on unexpected changes in expense items, including advertising and R&D. Regression of Alrnon lag model of sales on current and lagged advertising.
Ayanian ( I 983)
39 industries studied by Comanor & Wilson
Blattberg & Jeuland (1981)
Dietary Product (from Bass & Clarke (1972))
Found 90% duration intervals of 2.3 and 3.1 months
5% annual depreciation rate of advertising capita1
Bublitz & Ettredge (1989)
Publicly traded companies divided into durable and nondurable producers
Advertising duration of less than one year
Falk and Miller (1977)
Divisions of domestic auts companies and distributors of foreign autos
Quarterly (19 quziters beginning January 1970)
Advertising effectiveness was a long as five quarters for only two of the 25 firms
Table 5 List of Authors Abdel-Khalik, Advertising Effectiveness and Accounting Policv, 5 0 Acctg. Rev. 657 (1975). Ayanian, The Advertising Capital Controversy, 56 J. Bus. 349 (I 983). to Blattberg and Jeulard, A Micromodeline Ap~roach Investigate the Advertising-Sales Relationship, 27 Mgt. Sci. 988 (1981). Bloch, Advertising and Profitabilitv: A Reappraisal, 82 J. Pol. Econ. 267 (1974). Bublitz and Ettredge, The Information in Discretionarv Outlavs: Advertisinp Research, and Develo~ment, Acctg. Rev. 108 (1989). 64 Falk and Miller, Amortization of Advertising Ex~enditures, J. Acctg. Res 12 (1977). 15 s 30 Hirschey, Intangible Cauital A s ~ e c t of Advertising and R&D Ex~enditures, J. Ind. Econ. 375 (1982). Hirschey and Weygandt, Amortization Policy for Advertising and Research and D e v e l o ~ m e n t Ex~enditures, J. Acctg. Res. 326 (1985). 23 Picconi, A Reconsideration of the Recognition of Advertisine Assets on Financial Statements, 1 5 J. Acctg. Res. 317 (1977). Thomas, Advertising in Consumer Goods Industries: Durabilitv, Economies of Scale. and Heteropeneitv, 32 J. Law & Econ. 163 (1989). Winer, An Analysis of the Time-Varying Effects of Advertising: The Case of Lydia Pinkham,
52 J. Bus. 563 (1979).
Table 6 Regression of Tobin's Q On the Advertising to Sales Ratio By Year 1977 to 1986
Independent Variables: Ratio of Advertising to Sales Ratio of R&D to Sales Beta
Note: Absolute values of t-statistics in parenthesis. Regressions include up to 26 industry dummies.
ORGANIZATIONS AND COMPANIES SUPPORTING THIS STUDY
American Association of Advertising Agencies American Advertising Federation Association of National Advertisers American Newspaper Publishers Association Cox Enterprises Donrey Media Group Dow Jones & Co. Gannett, Co. Knight-Ridder, Inc. Media General, Inc. Magazine Publishers of America National Association of Broadcasters Newhouse (Advance Publications, 3nc.) Times Mirror Co. The New York Times The Washington Post Thornson Newspapers Scripps Howard Tribune Company Yellow Pages Publishers Association
ADVERTISlNG AND ENTRY: THE kPTERATUW
ADVERTISING AND E NTRY :
THE ECONOMICS LITERATURE
The recent economics literature shows that advertising generally facilitates market entry and expansion by enabling new or smaller firms to infom~consumers efficiently about their products. (See the discussion in Part 1I.B.) The earlier economics literature, however, viewed advertising as incompatible with and an instrument to suppress competition. The theoretical arguments offered to support the view that advertising is harmful to competition were essentially the following: Advertising enhances consumer brand loyalty which makes any attempt by new entrants to induce brand switching more difficult and thereby helps to insulate the incumbent advertiser against ~ompetition;~
Advertising is subject to economies of scale, making small-scale 2) inefficient;2 and
Some studies have concluded that advertising reduces price sensitivity, at least at the level of factory prices. See, e.g., Comanor & Wilson, Advertising and Market Power (1974); Lambin, Advertising, Competition, and Market Conduct in Oligopoly Over Time (1976). Others conclude that advertising increases retail price , sensitivity. See, e.g., Wittink, Advertising Increases Sensitivity to P ~ i c e17 J . Adv. Res. 39 (1977); Eskin, A Case for Test Marketing Experiments, I5 J. Adv. Res. 27 (1975); Eskin and Barron, Ef/^ect ofPrice and Advertising ii7 Test-Market Experiments, 14 J . MMg. Res. 499 (1977). Other studies have found that restrictions on advertising lead to both higher and less uniform prices. See, e.g., Benham, T17e Effect of Advertising on the Price ofEyeglasses, 15 3. Law & Econ. 337 (1 972); Cady, Adverfising Restrictions and Retail Prices, I6 3. Adv. Res. 27 (1976). The public goods nature of most advertising (i.e., that total resources expended do not increase in proportion to the number of individuals reached by the advertising) means that larger f m s may become more efficient (i.e., lower cost) relative to smaller f m s and thus the scale at which new f m s could enter would increase. But this results from the overwhelming efficiency of advertising over other methods of informing consumers (e.g., relying on consumer search alone) and neither leads to nor arises from market power. The empirical literature concerning economies of scale in advertising shows mixed findings. Brown, Estinzating Advantages to Large-Scale Advertising, 60 Rev. Econ. & Stat. 428 (1978) concludes that cigarette advertising exhibits economies to scale that would place a relatively small, new entrant at a disadvantage relative to larger, more established rivals. Arndt & Simon, Advertising and Economies of Scale: Critical Comments on the Evidence, 32 J . Ind. Econ. 229 (1983) argue, however, that it is virtually impossible to test directly for economies of scale with respect to advertising, since economies of scale imply that all inputs must be varied. Finally, Boyer & Lancaster, Are There Economies OjrSc~/e Advertising?, 59 3. BUS. 503 in (1986) criticize most previous studies for focussing on the cigarette industry, which operates under a television advertising ban. Boyer & Lancaster find that large national advertisers do not enjoy sales shares larger than their advertising shares. Thus they conclude that advertising is not characterized by scale economies.
Advertising is an "irreversible" investment in a durable asset and thus that an incumbent can use advertising to make entry unprofitable even in the absence of scale economies.3
A somewhat different, but related, set of arguments stemmed from work done in the
1960s on the relationship between concentration and profits. Much of that literature found that profits were positively related to industry concentration levels, from which they inferred that concentration lead to "monopoly" profit^.^ At the same time, they believed that advertising increased the likelihood of concentration by helping incumbents become entrenched.5 More
recent studies, however, have found that concentration does not reflect monopoly, but rather pro-competitive consolidations in a number of industries that lead to lower costs and increased profits.6 But if concentration is not by itself "bad," the foundation for the traditional hostility
irreversible investments are investments in assets (in particular, intangible assets) that cannot be sold except as part of the sale of the entire enterprise. Such irreversible investments may make entry more costly and thus less likely, but they are not barriers in themselves, any more than the need to build a specialized plant could be considered a barrier to entry. Moreover, our own work, infra, suggests that advertising is a relatively short-lived asset and thus is unlikely to constitute much of a barrier to entry.
See, e.g., Bain, supra, at -; , Relation of Profit Rate to Industry Concentration: American Manufacturing, 19.36-1940, 65 W.J. Econ. 293 (195 1); Mann, Seller Concentration, Barriers to Entry, and Rates of Return in Thirty Industries, 48 Rev. of Econ and Stat. 296 (1966). See, e.g., Comanor and Wilson, Advertising, Market Structure, Performance 49 Rev. Econ. & Stat. 423 ( 1 967); , Advertising and Market Power (1 974), and , Advertising and Competition: A Survey, 27 J. Econ. Lit. 453 (1979). See also, Nagle, Do Advertising-Profitability Studies Really Show that Advertising Creates a Barrier to Entry?, 24 J . Law & Econ. 333 (1981), who found that Comanor and Wilson's empirical support for their theory was driven by data outliers (i.e., observations that were well outside the range covered by the bulk of the data) and that there is no correlation between profitability and advertising intensity when these outliers are eliminated. See, e-g., Mueller and Rogers, Advertising and Industry Concentration, 62 Rev. Econ. & Stat. 89 (1980), who conclude that advertising (especially television advertising) leads to greater concentration in consumer goods industries. Lynk, Information, Advertising, and the Structure o f t h e Market, 54 J. Bus. 271 (1981) concludes the opposite: that television advertising leads to a reduction in size disparity among sellers. This "shift toward size equality occurs because the greater real flow of advertising messages...fosters a wider distribution of information about the products and sellers in the market." p. 302. Hirschey, The Effect of A dvertising on lndustrial Mobility, 194 7-1972, 54 J. Bus. 329 (I 981) Eckard, Advertising, Competition, and Market Share Instability, 60 J . Bus. 539 (1987) find that advertising upsets the market share stability of established fums. See, e.g., Brozen, Concentration and Structural and Market Disequilibria, 16 Antitrust Bull. 291 (1 971); Demsetz, Industy Structure, Market Rivalry, and Public Policy, 16 J . Law & Econ. 1 (1973); "Two Systems of Belief about Monopoly," in lndustrial Concentration: The New Learning 175 ( H . Goldschmid, U., 1974); Peltzman, The Gains and Losses Ji-om Industrial Concentration, 20 J. Law eds. & Econ. 229 (1977).
is severely eroded. Thus in more recent years, that view has given way to an interpretation of advertising as a means of providing information to consumers.7 The recent empirical literature has shown that advertising promotes market entry and expansion. A study by Lynk found that television reduced the real cost of advertising, provided consun~ers with more information, and had a deconcentrating effect in a number of industries. Lynk, Information, Advertising and the Structure o lhe Market, 54 J . Bus. 271 (1 981). f In
particular, Lynk finds that in industries where a relatively larger shift of advertising to television occurred, the size dispersion of firms fell, i-e., [a]n increase in the real volume of advertising messages causes an increase in the sales of smaller sellers relative to the sales of larger sellers...The conclusion is therefore that, in response to additional advertising, consumers readjust their patterns of purchase and, on balance, shift their patronage from larger, widely known brands and firms to smaller, preferred but previously unknown, seller^.^ Lynk, id. at 30 1-02. Gomes made a similar fmding. Gomes, The Competitive and Anticompetitive Theories of
Advertising: An Enzpirical Analysis, 18 Applied Econ. 599 (1 986). He tested two competing
theories of advertising's effect on entry: ( I ) the "anticompetitive" theory that advertising increases barriers to entry by increasing capital requirements and increasing consumer loyalty to existing brands and (2) the competitive theory that advertising promotes competition because it "erodes brand loyalties, reduces consumer's search costs for products, and thereby is a means for growth of small firms and entry of new firms." Id. at 602. His evidence supports the
competitive theory of advertising -- "advertising provides information about products, prices and sellers."
See, e.g., Nelson, supra, at -, as well as a number of other studies discussed in Part 1 . A above. 1
The Lynk study focuses on the effects of the advent of television on concent~ationin various industries. Although technically he examines the shifr of advertising into television, in fact, he uses this variable as a proxy for the overall increase in advertising messages that occurred as a result of the introduction of television.
Hirschey examines the relationship between advertising and entry and finds that between
contention that "advertising may be used to upset established market positions." Hirschey, supra, n. 13, at 29. Kessides finds some evidence that advertising expenditures constitute a sunk (i.e., irreversible) cost, but finds that "by providing information abaut the existence of alternative products and their price-quality characteristics [advertising] reduces the search costs faced by consumers, thereby decreasing their loyalty and inertia." Kessides, Advertising, Sunk Costs, and Barriers to Ently, 68 Rev. Econ. Stat 84 (1 986). On net, his empirical study shows that "for the majority of the industries examined [216 out of 2621, the overall impact of advertising on entry is positive, that is, advertising actually facilitates entry." Id. at 93. Finally, Eckard finds that prices rose less and output increased more between 1963 and 1977 in those industries which utilized television advertising than those that did not. He
concludes "The evidence provides stronger support for the view that advertising is procompetitive and that it has beneficial consumer welfare effects; i-e., it is associated with lower prices and greater output. Thus, increased market power is not the explanation for (or
consequence of) previously reported correlations between advertising levels and rising concentration." See, Eckard, Advertising, Concentration Changes, a n d Consunzer Welfare, 70 Rev. Econ. & Stat. 340, (1988) at 343. In short, although some early studies viewed advertising with hostility because of the positive correlation between advertising, concentration and profitability, more recent studies have pointed out that a positive correlation between advertising intensity and profitability is consistent with the theory, implied by Nelson, that firms with good products tend to advertise them in order to inform consumers. Consumers respond by sampling those products and then buying
Hirschey also examined data for an earlier period but found no significant effect. Eckard also finds that changes in industry concentration levels between 1963 and 1982 are umelared to industry advertising levels. Eckard, Advertising, Competition, and Market Share Stability, 60 J . Bus- 539.
them repeatedly, and thereby reward firms that have good products with greater sales and profits.
Table C.1 Distribution of Advertising in the Sunday Newspaper
Chicago Square Inches
San Francisco Square Inches
The Square Inches
Total Area Total Advertising Classified Advertising Non Classified Advertising DISTRIBUTION OF NONCLASSIFIED ADVERTISING: Total Price Advertising Price Only Short Term Price Plus Information
Short Term Image and Price
Short Term INFORMATIONAL DVERTISING A Information Only Information Plus Price S hart Term Information Plus Image IMAGE ADVERTISING Image Only Image and Price Short Term Image Plus Information
Table C.1 Distribution of Advertising in the Sunday Newspaper (continued)
Total area measures total area of the newspaper in square inches. Total advertising measures total area of the newspaper comprised by advertising. Classified advertising measures total area comprised by advertising in the Classified Advertising section of the newspaper. Price advertising includes advertisements, which principally convey price information. Short term denotes that the price information is valid for specified limited time, e.g., Thursday inserts advertising prices in effect for the next week only. Informational advertising includes advertisements, which principally convey information on quality, availability, or location of goods or services e.g., advertisements for vacation apartments available in Cancun. Image advertising includes advertising, which principally advertises exclusive services or products, e.g., advertisements for Tiffany diamonds.
Table C.2 Distribution of Advertising in the Monday Newspaper
Chicago Square Inches
San Francisco Square Inches
Tne Square Inches
Total Area Total Advertising Classified Advertising Non Classified Advertising DISTRIBUTION OF NONC L A S S F E D ADVERTISING: Total Price Advertising Price Only Short Term Price Plus Information Short Term Image and Price Short Term INFORMATIONAL ADVERTISING Information Only Information Plus Price Short Term Information Plus Image IMAGE ADVERTISING Image Only Image and Price Short Term Image Plus Information
Table C.2 Distribution of Advertising in the Monday Newspaper (continued)
Total area measures total area of the newspaper in square inches. Total advertising measures total area of the newspaper comprised by advertising. Classified advertising measures total area comprised by advertising in the Classified Advertising section of the newspaper. Price advertising includes advertisements, which principally convey price information. Short term denotes that the price information is valid fo specified limited time, e.g., Thursday inserts advertising prices in effect for the next week only. Informational advertising includes advertisements, which principally convey information on quality, availability, or location of goods or servicc e.g., advertisements for vacation apartments available in Cancun. Image advertising includes advertising, which principally advertises exclusive services or products, e.g., advertisements for Tiffany diamonds.
Table C.3 Distribution of Advertising in the Thursday Newspaper
Chicago Square Inches
San Francisco Square Inches
The Square Inches
Total Area Total Advertising Classified Advertising Non Classified Advertising DISTRIBUTION O F NONCLASSIFIED ADVERTISING: Total Price Advertising Price Only Short Term Price Plus Information Short Term
Image and Price
Short Term INFORMATIONAL ADVERTISING Information Only Information Plus Price Short Term Information Plus Image IMAGE ADVERTISING Image Only Image and Price Short Term Image Plus Information
Table C.3 Distribution of Advertising in the Thursday Newspaper (continued)
Total area measures total area of the newspaper in square inches. Total advertising measures total area of the newspaper comprised by advertising. Classified advertising measures total area comprised by advertising in the Classified Advertising section of the newspaper. Price advertising includes advertisements, which principally convey price information. Short term denotes that the price information is valid for specified limited time, e.g., Thursday inserts advertising prices in effect for the next week only. Informational advertising includes advertisements, which principally convey information on quality, availability, or location of goods or service! e.g., advertisements for vacation apartments available in Cancun. Image advertising includes advertising, which principally advertises exclusive services or products, e.g., advertisements for Tiffany diamonds.
ESTIMATING A KOYCK LAG
MODEL WITH DATA FROM MANY FIRMS
The analysis presented here illustrates the magnitude of the bias that results when the Koyclc lag model is applied to pooled data from more than one fm. We believe that this practice, common to many existing studies of advertising, results in substantial overstatement of advertising's useful life. We wish to state at the outset that, because the Koyck lag model suffers from many other serious flaws already noted, the empirical results we report here do not provide meaningful estimates of the useful life of advertising. In other words, although they are corrected for bias arising from one source (the pooling of data fi-om any firms), they still suffer from the other flaws inherent in the Kyock lag model. To illustrate the magnitude of the bias that arises when data from many firms are pooled, we estimated a Koyck lag model using data on over five hundred firms for the years 1983 to 1987.1 When cross-section time-series data are pooled without correcting for omitted variable bias, we find that the estimated effect of advertising on sales is positive and statistically significant for 12 of the 26 industries we analyze; the estimated coeEcient on lagged sales is statistically significant for all industries and greater than 0.8 for 19 of the 26.2 The estimated depreciation rates vary over a wide range: from less than one percent to more than 99 percent, with associated 90 percent duration intervals of less than one year to more than three hundred
The sales and advertising data are reported by Standard & Poor's Cornpustat Data Services, Inc. We estimate the model by industry, using CompuStat's information on each f m ' s two-digit SIC classification. The model is estimated using a double logarithmic specification. See Appendix E. IV for a full set of regression results and Appendix E. V for a listing of the data that underlie them. For three of the industries in the sample, the estimated effect of current advertising on current sales was negative which implies that advertising reduces sales. For one other industry, the coefficient on lagged sales was greater than one, and thus we could not estimate a meaningful depreciation rate. The depreciation rate is computed as the inverse of the coefficient on lagged sales minus one; thus coefficients greater than one would yield negative depreciation rates.
years.3 Most (13 out of 22) of the annual depreciation rates we estimated are less than fifteen
We then included a separate dummy variable for each of the 532 firms in the sample.4 By including these dummy variables, we were able to hold constant the effect of any omitted, firmspecific variables that might be correlated with sales and advertising, leaving the estimated depreciation rates free from spurious correlation.5 Using this methodology, we found that, while the effect of advertising on sales remained generally high and statistically significant (which suggests that currenf advertising has a large and statistically significant positive effect on current sales), the coefficient on lagged sales fell substantially both in size and (more important) in statistical si&icance. Thus, as expected, omitted variable bias leads to coefficients on lagged
sales that are biased towards one, which leads, in turn, to underestimated depreciation rates. Correcting for this bias, we estimated depreciation rates that still vary over a large range. But few (only 2 of 23) of the estimated annual depreciation rates were less than twenty-five percent and most exceeded fifty percent -- in fact, the majority exceeded seventy percent per year, while four show annual depreciation rates that are effectively one hundred percent. Consequently, the
estimated 90 percent duration intervals for advertising are much lower when spurious correlation is eliminated: seven out of twenty-three are one year or less in duration and another five are two years or less. These results suggest that many estimated depreciation rates previously reported
Estimated durations that exceed I00 years are clearly ludicrous, since they imply that the effect of advertising would outlive anyone exposed to it.
A fm specific dummy variable takes the value one when the observation in the regression corresponds to that fm and zero otherwise. This captures the effect of unmeasured firm specific factors, other than advertising and past sales, that contribute to the determination of current sales.
The correlation is considered "spurious" because it does not indicate a true causal relationship between the two variables (i.e., high levels of advertising do not cause high levels of sales). Rather, the correlation reflects the fact that high advertising and sales are caused by the same underlying factors, and these factors are not included in the regression explicitly. Of course, if there is no such correlation, then including the dummies will not affect the estimates, and the estimated depreciation rates also will not differ.
in the econon~ics literature are biased because there is substantial correlation across fmns between
Because we do not pretend to be able to correct for all the problems associated with the ICoyck lag model, we do not want to place any emphasis on lour precise findings for any industry. Our analysis is intended to illustrate the magnitude of the bias that results k o n ~ omitted variables, not to produce independent estimates of durability. We believe that the
conceptual flaws inherent in the Koyck lag model (in particular the inability to separate the effect (if any) of past advertising from other prior expenditures, like R&D and worker training, that are likely to be long-lived) render such an exercise htile.
In the most recent article on the subject, Thomas extends the Koyck lag model to include "brand quality" as one of the factors that might contribute to a f m ' s sales success. l other words, in Thomas's model, n advertising and "brand quality" have independent (but related) effects on sales. Thomas applies his model to two industries -- cigarettes and soft drinks -- and finds that it is brand quality and not advertising that explains a firm's success. Not surprisingly, he also finds that advertking is relatively short-lived: the estimated 90 percent duration interval for advertising in each of these industries is less than one year.
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