ADVERTISING

• Advertising aims to create subjective image differences and hence product differentiation.

• Product differentiation is a tool to increase profitability by decreasing the elasticity of demand.

Advertising plays a key role in the development of the market strategy

• Advertising allows firms to provide information directly to consumers.

• It helps firms to create or increase demand for their products.

• It allows firms to build a “brand image”.• It allows firms to differentiate their products.

Types of Advertising

• We distinguish between informal and persuasive adveritising.

• Informational (or informative) adveritisng is designed to provide truthful information about price,location or quality. (Does it?)

• Empricial evidence suggest that advertising about price (price advertising) results in lower prices.

• Do you think that advertising works? Does it change consumer behaviour?

• As an example: Apple Advertising may help manufacturers take advantage of economies of scale in production and distribution.

• Advertising is argued to improve quality. Since manufacturers build a brand image via advertising they try to live up to this image and increase the quality of production.

• Advertising may be seen as a commitment.• In real life we always face imperfect information.

Informative advertising increases market demand as more consumers become aware of the product.

• Informative advertising allows firms to increase demand but at the same time demand becomes more elastic. (Why?)

Persuasive Advertising

• In the real world advertising is more persuasive rather than informational.

• The main focus of advertising is to build brand loyalty. • Persuasive advertising is designed to influence

consumer tastes over a particular product.• Persuasive advertising creates/increases market power

because it is designed to persuade consumers that there is no/little substitues to their products.

• Moreover, brand loyalty is an important tool for an incumbent firm to set-up entry barriers.

• Informative advertising decreases market power/prices/profits.

• Persuasive advertising increases market power/prices/profits.

• So in a social welfare manner persuasive advertising decreases social welfare whereas informative advertising increases it. (Really?)

Cost of advertising (2009 US data-millions of dollars)

Rank Company Advertising exp.

1 Procter and Gamble 4189

2 Verizon 3020

3 AT&T 2797

4 General Motors 2215

5 Pfizer 2097

6 Johnson&Johnson 2061

7 Walt Disney 2004

8 Time Warner 1848

9 L’oreal 1834

10 Kraft Foods 1748

20 Nestle 1333

35 Pepsi 958

48 Coca-Cola 722

Advertising and Quality

• Phillip Nelson (1970,1974) developed a model on advertising.

• Consider two producers of toothpaste. Both toothpastes contain fluoride and have the Anerican Dental Association seal of approval. But the high-quality toothpaste tastes wonderful and the low quality toothpaste tastes horrible. The costs of production are assumed to be equal.

• Who has a higher incentive to advertise?

• Large advertising expenditures by high-quality toothpaste manufacturer signal consumers that it produces a high quality product. Because only high-quality producers advertise extensively. (Do you agree?)

Welfare Effects of Advertising

• Does advertising increase or decrease welfare?• Dixit-Norman model.• They analysed the welfare effects of

advertising in monopoly, oligopoly and monopolistic competition. Their conclusions were the same for all markets. We will only consider the monopoly model.

• From a social welfare perspective, all monopolists spend too much on advertising. Dixit and Norman showed that this result also holds for oligopoly and monopolistic competition.

• In this model advertising assumed to be purely persuasive, therefore had no social value.

• Some criticise the model arguing that informative advertising would have positive impact on social welfare. (Do you agree?)

• Another argument is that advertising may positively influence consumer’s utility by making them aware of the product. (Do you agree?)

Dorfman-Steiner Model

• This model is also constructed for monopoly.• In the model, only quantitiy is a function of

advertising. Price is independent of advertising.

• D-S condition states that the proportion of revenue a firm will spend on advertising is determined by the ratio of advertising elasticity to price elasticity.

• A monopolist will keep spending on advertising until the point it sets advertising to sales ratio equal to the ratio of the advertising-to-price elasticity.

• Since this is a monopoly model, market power is high and price elasticty is low so advertising expenditures will be high.

• In the D-S model profitability is linked to advertising expentiditures.

• The question is: Does a monopolist really needs advertising?