1、Advertising BasicsnProvided by someone with a definite agenda,but not necessarily the producer of the product.nProvided free-you do not pay directly for the advertising.nNot free to the firms,so there must be some benefit to them-increased profit.nIn general,industries with highest levels of adverti
2、sing also consumer good industries with highest profits.Advertising as Product DifferentiationnAdvertising as a wasteful,rent-seeking behavior.nOnce products are differentiated in the eyes of the consumer,the firms gain market power.uClassic monopolistically competitive model.uPrice will rise above
3、marginal cost.uThere will be deadweight loss.Monopolistic CompetitionAdvertising as a barrier to entrynIf an industry is characterized by a high level of advertising,potential entrants must invest heavily in advertising to“launch”new products.uFixed costs of entry increase,increasing scale at which
4、firm must compete in order to become profitable.uMay decrease the number of firms in an industry,thus increasing price.Advertising as part of a“prisoners dilemma”Marlboros(M)StrategiesDont AdvertiseAdvertiseCamels(C)StrategiesDontAdvertise$4 million(C)$4 million(M)$1.5 million(C)$5.5 million(M)Adver
5、tise$5.5 million (C)$1.5 million (M)$3 million(C)$3 million(M)Model of Advertising as a“Capture the Consumer”GamenConsumers know about a product category in general,but are not well informed about the characteristics of individual products.uExample:dont know where all the grocery stores in Williamsb
6、urg are located.nFirms advertise to inform consumers,but only some consumers“hear”the advertisements.“Capture the Consumer”Game ContnAssume two firms,X and Y.nProbability that any customer hears an advertisement from firm i is i.nThus(x*(1-y)consumers know about X,(y*(1-x)know about Y,xy are perfect
7、ly informed,(1-x)(1-y)are uninformed.“Capture the Consumer”Game ContnFirm only competes on price for perfectly informed consumers,so price is higher than it would be if all firms were perfectly informed.nAs firms try to reach more consumers,they must spend more money on advertising(diminishing retur
8、ns to advertising).nHigher price in part funds advertising.Positive Views on AdvertisingnAdvertising can be a“good”itself with a positive value to consumers.nAdvertising can provide information and lower a consumers search costs.uIn states with restrictions on price advertising(prescription drugs,al
9、cohol)prices are generally higher.nAdvertising can signal quality.Advertising as a Complement to Monopoly PowernAdvertising can help increase the value of a good.nAdvertising is a complement to primary good;consumers value joint consumption of the primary good and the ad.nFirms advertise to increase
10、 the demand for the primary good.nThis theory applies to a broad range of goods.Model of Advertising and Crowd AppealnTotal of N consumers in the market.nEach consumer will buy only one unit of the primary good.nEach consumer has a different value,vi,for the primary good.nAdvertising increases each
11、consumers value by the same factor,regardless of their initial value.Thus each consumers value with advertising is *vi.Model of Advertising and Crowd Appeal$QuantityMCDemand without advertisingProfit*Demand with advertisingModel of Advertising and Crowd Appeal,contnIncrease in consumers willingness
12、to pay,is a function of the amount spend on advertising,s.nAs s increases,(s)increases,as does consumer demand and profit.nFirms 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 an
13、d Crowd Appeal,contnIn this model,higher levels of advertising lead to higher prices because the advertising increases the consumers willingness to pay.nAlso,advertising can increase consumer surplus as well as firm profit,since advertising increases a consumers value.Model of Advertising as Informa
14、tionnTotal of N identical consumers in the market.nEach consumer will buy q(P)if informed about the product.nAdvertising informs consumers about the existence and/or usefulness of the product.nNumber of consumers informed depends on the amount spent on advertising.Model of Advertising as Information
15、$QuantityMCDemand with low advertisingProfitDemand with high advertisingModel of Advertising as Information,contnAs s increases,so does demand and profit.nFirms select advertising to maximize profit,i.e.,s where MR from s is equal to the MC of s.nIn this model,higher levels of advertising do not lea
16、d to higher prices.nAdvertising does increase consumer surplus as well as firm profit,since advertising increases the number of consumers that get a surplus.Comparison of these two modelsnComplementary Goods Model:uHigher advertising leads to higher demand for each consumer,which leads to higher pri
17、ces.nBrand Recognition Model:uHigher 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 AdvertisingnUse the Advertising as Information model.nAssume an informed consumer has a demand
18、 of q=a-bP.nThe number of informed consumers depends on the level of advertising,s.nTotal demand Q=n(s)(a-bP).nAssume 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,contnIf total demand Q=n(s)(a-b
19、P),then the inverse demand is P=a/b-Q/b*n(s)which we can rewrite as P=A-BQ/n(s).nProfits are=(A-BQ/n(s)-c)Q-s.nFirst find Q*given s by taking the derivative of profit w.r.t.Q and set=0.nA-2BQ/n(s)-c=0 Q*=(A-c)*n(s)/2B.nSo P*=A-B(A-c)*n(s)/2B/n(s)=(A+c)/2.More About the Optimal Level of Advertising,c
20、ontnAssume the firm increases s by one unit.What happens to profit?nQuantity sold will increase since Q*=(A-c)*n(s)/2B.Call this amount Qs.nP*is independent of s,so for the additional units sold,firm gets(P*-c).nSo MR from one more unit of s is Qs(P*-c).nThe firm will advertise until =Qs(P*-c).More
21、About the Optimal Level of Advertising,contnRemember from the lecture on price discrimination that the price-cost margin for a monopolist is a function of demand elasticity.n(P*-c)/P*=1/(Lerner index)nUse this with the condition for the optimal amount of s:=Qs(P*-c).nRearrange to get:=Qs(P*/)More Ab
22、out the Optimal Level of Advertising,contnSo now we have=Qs(P*/)/P*=Qs/.nMultiply both sides by s*/Q*to get:s*/P*Q*=s*Qs/Q*.nThe l.h.s.is just advertising expenditures/sales revenue(adv.to sales ratio).nThe r.h.s.can be broken down into two parts:s*Qs/Q*and.nThe first is the elasticity of demand w.r
23、.t.adv.and the second is price elasticity.More About the Optimal Level of Advertising,contnSo 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.nThis is known as the Dorfman-Steiner conditio
24、n.nThe more price inelastic demand is,the more should be spent on advertising.nThe more advertising elastic demand is,the more should be spent on advertising.More About the Optimal Level of Advertising,contnNote:critics often argue that advertising makes consumers more brand loyal,i.e.makes demand i
25、nelastic.nThis 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 Advertisingn“Shopping”goods:Relatively expensive and infrequently purchased,so you shop around for them.uCars,computers,
26、furniture.uAdvertising relatively unimportant,you gather a lot of data on your own.n“Convenience”goods:Relatively inexpensive and frequently purchased.uShampoo,soda,beer.uAdvertising relatively effective.Elasticity of Demand w.r.t.Advertising,contnAdd in Nelsons categorization of“Search”vs.“Experien
27、ce”goods.uSearch:Quality can be identified before purchase.Consumers search for the best total package of price and quantity.uExperience: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.Advertisin
28、g,contSearchExperienceShoppingLowestadvertisingelasticityConvenienceHighestadvertisingelasticityDorfman-Steiner in ActionSearchExperienceShoppingClothes 2.3Furniture 2.6Jewelry 2.5Hotels 3.5Appliances 4.3Footwear 4.5ConvenienceGreeting Cards3.7Retail FoodStores 1.4Soap/Detergent7.9Beer 8.4Books 4.0A
29、dvertising and SignalingnFor experience goods,advertising can also be used to signal quality.nIf 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.uPrice is can also be used as a signal of high qualit
30、y.Free Rider Problem in AdvertisingnAdvertising can have positive externalities for other firms in an industry.nWith positive externalities,there will be too little advertising due to free-riders.nThus we might suspect that in industries with large numbers of firms(and thus large positive externalities)advertising levels would be relatively low.uSupported by about 1/2 of studies.Free Rider Problem contnOne solution is group or cooperative advertising.uGot Milk?Campaign.uPlastics council.uMcDonalds.
