Advertising Basics


Provided by someone with a definite
agenda, but not necessarily the producer
of the product.

Provided free -- you do not pay directly
for the advertising.

Not free to the firms, so there must be
some benefit to them -- increased profit.

In general, industries with highest levels
of advertising also consumer good
industries with highest profits.
Advertising as Product
Differentiation

Advertising as a wasteful, rent-seeking
behavior.

Once products are differentiated in the
eyes of the consumer, the firms gain
market power.
 Classic monopolistically competitive model.
 Price will rise above marginal cost.
 There will be deadweight loss.
Monopolistic Competition
Advertising as a barrier to
entry

If an industry is characterized by a high
level of advertising, potential entrants
must invest heavily in advertising to
“launch” new products.
 Fixed costs of entry increase, increasing
scale at which firm must compete in order
to become profitable.
 May decrease the number of firms in an
industry, thus increasing price.
Advertising as part of a
“prisoner’s dilemma”
Marlboro’s (M) Strategies

Don't Advertise Advertise

Camel’s (C) Don't $ 4 million (C) $1.5 million (C)
Strategies Advertise $ 4 million (M) $5.5 million (M)

Advertise $5.5 million (C) $3 million (C)

$1.5 million (M) $3 million (M)
Model of Advertising as a
“Capture the Consumer” Game

Consumers know about a product category
in general, but are not well informed about
the characteristics of individual products.
 Example: don’t know where all the grocery
stores in Williamsburg are located.

Firms advertise to inform consumers, but
only some consumers “hear” the
advertisements.
“Capture the Consumer” Game
Con’t

Assume two firms, X and Y.

Probability that any customer hears an
advertisement from firm i is i.

 Thus (x*(1-y)) consumers know about X,

(y*(1-x)) know about Y, xy are perfectly

informed, (1-x)(1-y) are uninformed.

“Capture the Consumer” Game
Con’t

Firm only competes on price for perfectly
informed consumers, so price is higher
than it would be if all firms were
perfectly informed.

As firms try to reach more consumers,
they must spend more money on
advertising (diminishing returns to
advertising).

Higher price in part funds advertising.
Positive Views on Advertising

Advertising can be a “good” itself with a
positive value to consumers.

Advertising can provide information and
lower a consumer’s search costs.
 In states with restrictions on price
advertising (prescription drugs, alcohol)
prices are generally higher.

Advertising can signal quality.
Advertising as a Complement to
Monopoly Power

Advertising can help increase the value of a
good.

Advertising is a complement to primary
good; consumers value joint consumption of
the primary good and the ad.

Firms advertise to increase the demand for
the primary good.

This theory applies to a broad range of
goods.
Model of Advertising and Crowd
Appeal

Total of N consumers in the market.

Each consumer will buy only one unit of the
primary good.

Each consumer has a different value, vi, for
the primary good.

Advertising increases each consumer’s value
by the same factor, , regardless of their
initial value. Thus each consumer’s value
with advertising is  * vi.
Model of Advertising and Crowd Appeal
$
*
Demand with
advertising

Demand without
advertising
Profit
MC

Quantity
Model of Advertising and Crowd
Appeal, con’t

Increase in consumers’ willingness to pay,
, is a function of the amount spend on
advertising, s.

As s increases, (s) increases, as does
consumer demand and profit.

Firms will select the level of advertising
that maximizes profit, i.e., the level of s
where the marginal revenue from s is
equal to the marginal cost of s.
Model of Advertising and Crowd
Appeal, con’t

In this model, higher levels of advertising
lead to higher prices because the
advertising increases the consumers’
willingness to pay.

Also, advertising can increase consumer
surplus as well as firm profit, since
advertising increases a consumer’s value.
Model of Advertising as
Information

Total of N identical consumers in the
market.

Each consumer will buy q(P) if informed
about the product.

Advertising informs consumers about the
existence and/or usefulness of the
product.

Number of consumers informed depends on
the amount spent on advertising.
Model of Advertising as Information
$

Demand with
high advertising

Demand with low

Profit
advertising

MC

Quantity
Model of Advertising as
Information, con’t

As s increases, so does demand and profit.

Firms select advertising to maximize profit,
i.e., s where MR from s is equal to the MC of s.

In this model, higher levels of advertising do
not lead to higher prices.

Advertising does increase consumer surplus as
well as firm profit, since advertising increases
the number of consumers that get a surplus.
Comparison of these two models

Complementary Goods Model:
 Higher advertising leads to higher demand
for each consumer, which leads to higher
prices.

Brand Recognition Model:
 Higher levels of advertising leads to more
consumers but not a higher demand for
each consumer, so prices are not affected
by advertising levels.
More About the Optimal Level
of Advertising

Use the Advertising as Information model.

Assume an informed consumer has a demand
of q = a-bP.

The number of informed consumers depends
on the level of advertising, s.

Total demand Q = n(s)(a-bP).

Assume that the firm has a constant
marginal cost of production of c and a
constant marginal cost of advertising, .
More About the Optimal Level
of Advertising, con’t

If total demand Q = n(s)(a-bP), then the
inverse demand is P = a/b - Q/[b*n(s)]
which we can rewrite as P = A - BQ/n(s).

Profits are =(A-BQ/n(s)-c)Q - s.

First find Q* given s by taking the
derivative of profit w.r.t. Q and set = 0.

A-2BQ/n(s) - c = 0  Q* = (A-c)*n(s)/2B.

So P*=A-B[(A-c)*n(s)/2B]/n(s) = (A+c)/2.
More About the Optimal Level
of Advertising, con’t

Assume the firm increases s by one unit.
What happens to profit?

Quantity sold will increase since
Q* = (A-c)*n(s)/2B. Call this amount Qs.

P* is independent of s, so for the
additional units sold, firm gets (P* - c).

So MR from one more unit of s is Qs(P*-c).

The firm will advertise until  = Qs(P*-c).
More About the Optimal Level
of Advertising, con’t

Remember from the lecture on price
discrimination that the price-cost margin
for a monopolist is a function of demand
elasticity.

(P*-c)/P* = 1/ (Lerner index)

Use this with the condition for the
optimal amount of s:  = Qs(P*-c).

Rearrange to get:  = Qs(P*/)
More About the Optimal Level
of Advertising, con’t

So now we have =Qs(P*/)  /P* = Qs/.

Multiply both sides by s*/Q* to get:
s*/P*Q* = s*Qs/Q*.

The l.h.s. is just advertising expenditures/
sales revenue (adv. to sales ratio).

The r.h.s. can be broken down into two parts:
s*Qs/Q* and .

The first is the elasticity of demand w.r.t.
adv. and the second is price elasticity.
More About the Optimal Level
of Advertising, con’t

So the optimal advertising to sales ratio should
be the same as the ratio of the elasticity of
demand w.r.t to advertising to the elasticity of
demand w.r.t. price.

This is known as the Dorfman-Steiner condition.

The more price inelastic demand is, the more
should be spent on advertising.

The more advertising elastic demand is, the
more should be spent on advertising.
More About the Optimal Level
of Advertising, con’t

Note: critics often argue that advertising
makes consumers more brand loyal, i.e.
makes demand inelastic.

This derivation shows that the causation
could be the other way around: Because
demand is price inelastic, more advertising
is optimal.
Elasticity of Demand with
respect to Advertising

“Shopping” goods: Relatively expensive and
infrequently purchased, so you shop around for
them.
 Cars, computers, furniture.
 Advertising relatively unimportant, you gather a
lot of data on your own.

“Convenience” goods: Relatively inexpensive and
frequently purchased.
 Shampoo, soda, beer.
 Advertising relatively effective.
Elasticity of Demand w.r.t.
Advertising, con’t

Add in Nelson’s categorization of “Search”
vs. “Experience” goods.
 Search: Quality can be identified before
purchase. Consumers search for the best
total package of price and quantity.
 Experience: Quality can only be
determined after consumption. Consumers
try different goods to determine whether
or not to continue to use.
Elasticity of Demand w.r.t.
Advertising, con’t
Search Experience

Shopping Lowest
advertising
elasticity
Convenience Highest
advertising
elasticity
Dorfman-Steiner in Action

Search Experience

Shopping Clothes 2.3 Hotels 3.5

Furniture 2.6 Appliances 4.3
Jewelry 2.5 Footwear 4.5
Convenience Greeting Cards Soap/Detergent
3.7 7.9
Retail Food Beer 8.4
Stores 1.4 Books 4.0
Advertising and Signaling

For experience goods, advertising can also
be used to signal quality.

If a company engages in an expensive ad
campaign, you might infer that the good is
high quality because only high quality
firms could afford the campaign.
 Price is can also be used as a signal of high
quality.
Free Rider Problem in
Advertising

Advertising can have positive externalities
for other firms in an industry.

With positive externalities, there will be
too little advertising due to free-riders.

Thus we might suspect that in industries
with large numbers of firms (and thus
large positive externalities) advertising
levels would be relatively low.
 Supported by about 1/2 of studies.
Free Rider Problem con’t

One solution is group or cooperative
advertising.
 Got Milk? Campaign.
 Plastics council.
 McDonald’s.