PART III PRICE AND NON-PRICE STRATEGIES III.4 ADVERTISING

PART III PRICE AND NON-PRICE STRATEGIES

III.4 ADVERTISING

Examples

Pharmaceutical sector

- Similar expenses in marketing activities and in R&D - Necessary marketing expenses? Wasteful?

Soft drinks

- Price competition plays a secondary role wrt advertising competition

In this chapter

- Advertising is considered with a strategic perspective

III.4.1 INFORMATION, PERSUASION, SIGNALING

To analyze the possible effects of advertising, classify goods in 3 categories:

- Search goods (PC)

- Experience goods (restaurants) - Credence goods (medical services)

Classify advertising activities:

- Informative advertising (information about characteristics) - Persuasive advertising (to influence consumers’ preferences)

Links:

- Informative advertising mainly associated with search goods

- Empirical evidence: advertising/sales ratio is 3x higher for experience goods than it is for search goods

Social value of advertising?

- Is informative advertising the only one with social value?

- Look for efficiency arguments

Signaling

- Persuasive advertising can be considered as an indirect informative advertising for some experience goods

- Example: Ford, Diet Coke at launch

- At launch, we have very little information - We only know that advertising is expensive

Signaling

- Advertising expenditure can signal quality - Ingredients:

! dynamic perspective (does not work for one-period goods)

! Experience goods (no information about the quality, the characteristics) - Signaling theory:

! Averse selection

! Market failure

! Signaling

! Credibility, interpretation of signals

! Signals expensive enough, not too much

III.4.2 ADVERTISING INTENSITY

- To measure advertising intensity, compute a/R, where a are the advertising expenses and R is the revenue from sales.

- Examples:

! In the salt industry, a/R is of the order of 0% to 0.5%

! For breakfast cereals, it is between 8% and 13% (Sutton’s estimates)

- How do we explain such differences?

Factor 1: Demand elasticity w.r.t. advertising

- Consider the following demand: D(a, p)

- Define demand elasticity w.r.t. advertising as

€

η

∂

∂

a D(a, p)

- Some markets are more sentitive/reactive to variations in advertising than others.

p   p  

q   q  

Low  η   ^High  η  

Factor 2: Demand elasticity w.r.t. price

- Consider the following demand: D(a, p) - Define demand elasticity w.r.t. price as

€

ε

∂

∂

p D(a, p)

- Some markets are more sentitive/reactive to variations in prices than others.

- Advertising is more effective in markets with a low price elasticity of demand because prices are generally higher in such markets.

p   p  

q   q  

Low  ε   ^High  ε  

Also,  ads  can  decrease  the   price  elasticity  of  demand  

Formally

A monopoly:

€

Maxp,a Π =(p −c)D(p,a)− a

FOC w.r.t. p implies the inverse elasticity rule

€

p − c

p = 1

ε

FOC w.r.t. a implies

€

a

R = p −c p

η

Combining both FOC, we obtain the Dorfman-Steiner formula:

€

a

R =

η ε

- Advertising intensity increases with η and decreases with ε^.

- Empirical support

Factor 3: Market structure

Higher advertising intensity in concentrated markets or in more competitive markets?

How do ε ^and η vary with the number of firms, n?

- ε increases with the number of firms, n

! By decreasing its price, a firm not only increases total demand, but also its market share.

! The second effect is greater for smaller firms.

! Therefore, price elasticity of demand is higher in markets with many small firms.

! Advertising intensity is therefore lower in markets with many firms.

- How does η vary with the number of firms, n?

2 extreme cases

1. If advertising increase the demand for all firms equally

! Examples: milk, diamonds

! Advertising = public good

! The higher n, the more we share the benefits from advertising

! η decreases with the number of firms, n

! Less incentives to invest in advertising when n is high

! Example: Diamonds (distribution by DeBeers vs Russian producers)

2. The total demand is given, only market shares vary (Hotelling)

! Examples: pharmaceuticals

! Effect of ads: consumers switch from brand-name drugs to generics

! In a monopoly, η ^{= 0}

! In a duopoly, η ^{> 0}

! In a concentrated market, η increases with the number of firms, n

! More incentives to invest in advertising when n increases

To sum up, as n increases, we have 3 effects:

- markets shares are lower, ε is higher, a/R decrease

- Each firm captures a smaller share of the positive effect of advertising - Hotelling

" The total effect is ambiguous.

Empirically:

- For high initial n, advertising intensity decreases with n - For low initial n, advertising intensity increases with n

III.4.3 PRICE COMPETITION AND ADVERTISING

Interactions between the advertising strategies of competing firms.

- Prisonners dilemma for advertising expenses (as for price setting)

- If total demand is constant (Hotelling), each firm engages in advertising until profits are zero

- Idem Bertrand competition

- This result on advertising can be nuanced in the same way as the Bertrand results - Example: repeated interactions can decrease such wasteful advertising activities.

Collusion and advertising strategies

- Different timing between advertising strategies and price strategies:

! Decisions: frequent for prices, less frequent for advertising

! Effects: short-term for prices, long-term for advertising

! Time-discount factor likely to be lower for advertising activities

! A collusive agreement on advertising activities is more difficult to sustain than one on prices

Interaction between price competition and advertising competition

- Advertising can soften price competition

! Generally, persuasive advertising increases product differentiation

! Therefore, it softens price competition

! Not only is advertising wasteful, but it is also anti-competitive

! But, how do we compare total surplus with and without advertising if consumer preferences vary?

! Moreover, adbertising increases the quantities exchanges, which argues in favor of advertising, even persuasive

- Advertising can intensify price competition

! Informative advertising on prices decreases search costs

! Therefore, price competition intensifies

! But then, why would firm invest in such informative advertising?

! Prisonners dilemma again?