Lecture Notes 13: Advertising
Advertising is ubiquitous and consumes substantial resources. Worldwide, media advertising expenditures in 2015 were about $570 billion, which is more than the GDP of all but about 20 countries. Firms in some markets spend significant shares of their revenue on advertising. While auto manufacturers spend 2-3% of their revenues on advertising, it is not unusual for fast-food restaurants and pharmaceutical firms to spend as much as 10% of their revenues on advertising.
Advertising can serve a number of purposes for a firm, and the welfare effects of advertising for society are a mixed bag. In this unit, we will cover the important ideas.
Profit-Maximizing Advertising for a Firm
Let’s start from the basics by characterizing a firm’s optimal level of advertising. The firm’s demand function in this extended model is 𝑞𝑞(𝑃𝑃, 𝐴𝐴), and depends both on its price 𝑃𝑃 and on its advertising 𝐴𝐴. The firm incurs a production cost 𝑐𝑐 for each unit of output it produces, and we normalize advertising so that it costs $1 per unit. The firm’s profit is therefore given by:
Π = 𝑃𝑃 ⋅ 𝑞𝑞(𝑃𝑃, 𝐴𝐴) − 𝑐𝑐𝑞𝑞(𝑃𝑃, 𝐴𝐴) − 𝐴𝐴
To maximize profit, we take the first-order conditions with respect to 𝑃𝑃 and with respect to 𝐴𝐴.
𝑑𝑑Π
𝑑𝑑𝑃𝑃 = 𝑞𝑞 + 𝑃𝑃 ⋅ 𝑑𝑑𝑞𝑞 𝑑𝑑𝑃𝑃 − 𝑐𝑐 ⋅
𝑑𝑑𝑞𝑞 𝑑𝑑𝑃𝑃 = 0 𝑑𝑑Π
𝑑𝑑𝐴𝐴 = 𝑃𝑃 ⋅ 𝑑𝑑𝑞𝑞 𝑑𝑑𝐴𝐴 − 𝑐𝑐 ⋅
𝑑𝑑𝑞𝑞
𝑑𝑑𝐴𝐴 − 1 = 0
Let’s consider the second expression, to characterize the optimal level of advertising.
𝑑𝑑𝑞𝑞
𝑑𝑑𝐴𝐴 ⋅(𝑃𝑃 − 𝑐𝑐) − 1 = 0 𝑑𝑑𝑞𝑞 𝑑𝑑𝐴𝐴 =
1 𝑃𝑃 − 𝑐𝑐
Now multiply both sides by 𝐴𝐴
𝑞𝑞.
𝑑𝑑𝑞𝑞 𝑑𝑑𝐴𝐴 ⋅
𝐴𝐴 𝑞𝑞 =
1 𝑃𝑃 − 𝑐𝑐 ⋅
Multiply the right side by 𝑃𝑃
𝑃𝑃 and rearrange.
𝑑𝑑𝑞𝑞 𝑑𝑑𝐴𝐴 ⋅
𝐴𝐴 𝑞𝑞 =
𝑃𝑃 𝑃𝑃 − 𝑐𝑐 ⋅
𝐴𝐴 𝑃𝑃𝑞𝑞
Let’s consider each piece of this expression.
• The left side 𝑑𝑑𝑞𝑞
𝑑𝑑𝐴𝐴⋅ 𝐴𝐴
𝑞𝑞 is known as the advertising elasticity of demand𝜀𝜀𝐴𝐴. This is the percent
change in demand that results from each 1% increase in advertising.
• The expression 𝐴𝐴
𝑃𝑃𝑞𝑞 gives the share of the firm’s total revenues that it spends on advertising.
We’ll call this 𝜎𝜎𝐴𝐴.
• The expression 𝑃𝑃
𝑃𝑃−𝑐𝑐 is the inverse of the Lerner Index. Remember from our unit on market
power the basic Lerner Index condition 𝑃𝑃−𝑐𝑐
𝑃𝑃 = 1
|𝜀𝜀|, where 𝜀𝜀 is the price elasticity of demand.
The expression given is the inverse, so 𝑃𝑃
𝑃𝑃−𝑐𝑐 = |𝜀𝜀|
Making these three substitutions into our expression gives us a simple characterization.
𝜀𝜀𝐴𝐴 = |𝜀𝜀| ⋅ 𝜎𝜎𝐴𝐴
Rearranging gives us what we want.
𝜎𝜎𝐴𝐴 = 𝜀𝜀𝐴𝐴 |𝜀𝜀|
This is a very well-known expression called the Dorfman-Steiner condition. It relates the share of a firm’s revenues that it should spend on advertising to its advertising elasticity and to its price elasticity.
The first part is obvious. When advertising is more effective (larger increase in demand for additional advertising expenditures), the advertising elasticity is higher and the firm should spend more on advertising.
advertising locks in brand loyalty and creates more inelastic demand. But, no matter which direction the causality runs, the association is well-known in any case.
Advertising as Pure Waste
Our advertising model starts from a supposition that a firm’s demand depends on its level of advertising and then characterizes optimal advertising spending from there. Surely that’s a basic condition. In order for it to make sense for a firm to spend money on advertising, the advertisements must create new sales.
But we left as an open question how advertising stimulates demand. Does it provide information and bring new customers into the market for the product? Does it lock in your customers and make them like the product better? Or does it just poach existing customers from other firms?
The last case is the worst kind of advertising from the perspective of society, and the existence of advertising here generates an unequivocal welfare loss.
Here is a simple example. Suppose Firm A and Firm B are in a market with $100 of total sales. If neither runs advertisements or if both run advertisements, the firms split the market evenly. However, if only one firm runs advertisements, it can steal $20 of business from the non-advertiser. Finally, running advertisements costs $10. Let’s model this scenario as a game.
No Ads Ads
No Ads $50, $50 $30, $60
Ads $60, $30 $40, $40
Clearly, the efficient outcome is for neither firm to run ads, but the problem is a prisoners’ dilemma. If neither firm runs ads, each firm on its own has an incentive to defect and run ads to increase its own profit. Ultimately, the Nash Equilibrium is for both firms to run ads.
There is an interesting case study along these lines. The US banned cigarette advertising on TV in 1971. The firms complained loudly that their profits would fall, but they actually went up! By making advertising illegal, the government in effect solved the prisoners’ dilemma for the tobacco companies.
Informational Advertising
A more charitable model of advertising would incorporate the notion that advertising might convey useful information of some sort to consumers. This leads to the possibility (though not the certainty) of welfare gains from advertising. Advertising that conveys information about a product’s characteristics is called informational advertising, whereas advertising that is designed purely to influence consumers’ tastes is called persuasive advertising.
One kind of advertising with an unequivocally positive impact on welfare is price advertising. Advertising that conveys information on price is good for society. Giving consumers low-cost information about prices reduces their search costs, and makes it less likely that firms will be able to get away with charging high markups. There are many empirical studies across all different kinds of industries that show that advertising about price reduces prices paid by consumers.1
If the advertising is about the existence of a product, then there is actually too little advertising relative to the efficient level. The total welfare increase generated by informing customers about the product includes the new consumer surplus and the new producer surplus. But the firm captures only the producer surplus. Thus, even if the total welfare generated (CS+PS) is sufficient to justify paying to inform the consumer about the product, the firm may not do so if the producer surplus is insufficient to cover the cost.2
Advertising to Overcome Adverse Selection
Let’s start by distinguishing between two different types of goods.
• Search goods are goods for which the consumer can examine the quality before purchase. Examples might be furniture or clothes.
• Experience goods are goods for which the consumer has to actually purchase and consume the good in order to get an indication of the quality. Examples might be packaged foods, computer programs or psychotherapy.
The problem with experience goods is that the market can suffer from adverse selection (also called the lemons problem). Since the consumer can’t determine quality, he is just as apt to buy a low-quality product as he is to buy a high-quality product. Low-quality products are cheaper to produce and generate more profit for the firm. In the end, low-quality products take over the market if there is no way for manufacturers of high-quality products to distinguish themselves. Could advertising be a way?
1 At one point, doctors and lawyers tried to prohibit price advertising through their professional organizations on the
Here’s a simple model. Think about an experience good that the consumer has to actually buy and use in order to determine the quality. Now suppose an advertisement lures a consumer into trying out an experience good.
• Consider a firm that produces a high-quality product. The advertising generates new customers who try the product, like it, keep buying it over and over again, and maybe even telling their friends. Overall, the advertisement generates multiple sales for each customer it reaches.
• Consider a firm that produces a low-quality product. The advertising generates new customers, but after they try the product and realize that it’s low-quality they never come back again and they tell their friends to stay away. The advertisement generates only one sale for each customer it reaches.
In this model, high-quality firms have more of an incentive to advertise. Sellers of high-quality products generate multiple sales for each customer reached by an ad. Sellers of low-quality products generate only one sale for each customer reached by an ad. Economists say in this case that advertising is a signal about the quality of the product. It’s not that it’s impossible to advertise lousy products, but it’s much more worthwhile for a firm with a good product to advertise it. Thus, advertising can serve as a signal to consumers that the product is good.
This is informative advertising of a different sort. It’s not that the advertisement contains any useful information per se. But advertising in this model is informative to consumers in an indirect sense because consumers infer that it is more profitable for firms with high-quality products to run them.
Persuasive Advertising to Change Preferences
In the examples considered above, advertising did not change the consumer’s underlying preferences. It just provided some information (either directly or through signaling). But what about the possibility that advertising might actually mold preferences? In other words, maybe you actually come to place a higher value on something because of a marketing campaign. For example, an ad doesn’t just inform you about a singer, it actually makes you enjoy her songs more.
The standard treatment of this problem is Dixit and Norman (1978). We will not go through the details, but here are the main results of the model.
• Some level of persuasive advertising can be welfare-enhancing in markets with market power. The welfare improvement comes because the expansion of demand causes firms to increase their output, which reduces deadweight loss from monopoly.
• However, the level of persuasive advertising is too high relative to the efficient level. This is because firms can pass some of the advertising costs onto consumers and do not take this welfare reduction into account when choosing its advertising level.
The issue of whether advertising changes underlying preferences is a deep question that is still unsettled to some extent. Suppose advertising a particular brand of jeans makes you want to wear them because it seems more popular to do so. Did it really change your underlying preferences for the jeans themselves, or is it more accurate to say that the advertising is a complementary good? Deep questions about the malleability of underlying preferences are a foundational question that has challenged economists for generations.
Advertising as a Barrier to Entry
Another reason for firms to run advertisements is strategic – heavy advertising can constitute a barrier to entry for new firms. This barrier to entry can come about for two reasons.
First, if advertising is persuasive and builds goodwill with customers, then new entrants have a large and costly hurdle to overcome in order to be competitive. Incumbent firms have a stock of goodwill, and it takes large marketing expenditures for a newcomer to create its own stock of goodwill from scratch.
Second, persuasive may create spurious product differentiation whereby consumers believe that brands are distinct even when the products are physically identical. A classic example is Nutrasweet. Nutrasweet is, in fact, nothing more than aspartame, which is a generic and easy-to-produce chemical. Yet, through heavy marketing, Nutrasweet has achieved a substantial market share that would be expensive for a new firm to overcome – even if the products are literally identical. Other examples are bottled water and most over-the-counter drugs.
A related point we hinted at in our discussion of spatial models is that advertising can increase product differentiation (even if it’s spurious), and soften price competition as a result.
Advertising and Market Structure
Having gone through some of the most important motivations for advertising by firms, let’s think about the relationship between advertising and market structure. Recall the Dorfman-Steiner condition.
𝜎𝜎𝐴𝐴 = 𝜀𝜀𝐴𝐴 |𝜀𝜀|
Using this equality, we obtain two results.
• Advertising should be lower in industries with more price elastic demand. This implies that we should see less advertising in markets that are more competitive. Indeed, in a perfectly competitive market there is no point for any individual firm to run advertisements because there is nothing to differentiate their own products and the firms have no ability to stimulate their own demand versus any other firm’s demand.3 Advertising is basically a
public good in perfectly competitive industries.
• Advertising should be higher in industries with more advertising elastic demand. In this case, it’s possible that a larger number of firms in the market leads to more advertising-elastic demand and more advertising. The reason is simple. There are more competitors to poach from – so advertising in industries with many firms has more potential to increase sales by a greater amount, because there are more rivals to steal customers from.
Overall, empirical evidence suggests that the relationship between advertising and market structure is ambiguous. There is no clear answer.
False Advertising
We’ll close this unit with a discussion of false advertising. False advertising is illegal in the United States, but the truth is that enforcement is spotty at best, and many firms run deceptive advertisements for years without any real consequences for doing so. Surprisingly, as we will see, enforcement of laws against false advertising might counterintuitively lead to more false advertising.
In theory, our model of advertising to overcome adverse selection suggests that deceptive advertising for lousy products shouldn’t be very profitable because the ads won’t generate any repeat business. Unfortunately, if a firm produces a low-quality product and its production costs
3 Indeed, firms in competitive industries often form advertising cooperatives where all firms contribute money to ad
are low enough, deceptive advertising might still be profitable even if it only generates one sale for each customer exposed to the advertisement.
Overall, despite our theoretical model that suggests otherwise, studies across many different industries show that there is not much evidence that greater advertising signals better quality. It turns out that advertising isn’t really a useful signal of the quality of experience goods.
Why not rigorously enforce laws that prohibit deceptive advertising? Such enforcement may actually lead to more deceptive advertising. Here is the basic argument. If it’s public knowledge that the government doesn’t enforce laws against deceptive advertising, then consumers don’t believe the ads in the first place. In other words, there’s no point in running a false ad because consumers don’t put much faith in any ads they see. On the other hand, if consumers believe that the government stringently enforces laws against deceptive advertising, then they are more likely to have confidence in the ads they see, and so there is more benefit for a firm to try to sneak a deceptive ad through. That is, unless enforcement is perfect, laws against deceptive advertising may lead to more deceptive ads because there is more benefit for firms to at least try.
On the other hand, enforcement of laws against deceptive advertising also encourages more revelation of accurate information as well, again because consumers place more confidence in the information they get from advertisements. Overall, laws against deceptive advertising encourage firms to put out more of all kinds of information – true and false. Regulators have to consider this tradeoff when enforcing laws.
What about taking this a step further – disclosure laws that require firms to disclose certain features of products? (rather than simply banning untruthful information). The benefit is that disclosure laws in theory should help to overcome the adverse selection problem by making information about product quality public knowledge. On the other hand, firms may fail to conduct appropriate tests and screening if they know that they’re going to have to disclose the results.
Exercises
Problem 1
Suppose that a monopoly’s demand curve is 𝑃𝑃 = 1000 + 𝐴𝐴 − 0.05𝑞𝑞, where 𝑞𝑞 is the level of output and 𝐴𝐴 is the level of advertising. Each unit of advertising costs $𝑚𝑚 and each unit of output costs $𝑐𝑐 to produce. What are the profit maximizing price, output and level of advertising? Your answers may depend on 𝑚𝑚 and 𝑐𝑐.
Problem 2
A firm faces a price elasticity of 𝜀𝜀 = −2 and an advertising elasticity of 𝜀𝜀𝐴𝐴 = 0.1.
a. Determine the firm’s optimal advertising to sales ratio.
b. If the firm’s revenues are $50,000, how much should it spend on advertising?
Problem 3
You are the manager of a car dealership. Last year, the company spent $1 million on advertisements out of its total sales revenues of $25 million. You hired a marketing consultant and you have a report showing that each 2% increase in advertising expenditures would lead to a 10% increase in car sales. But it would take a 5% price cut to generate a 10% increase in car sales. What should you do to your firm’s level of advertising?
Problem 4
How could an advertisement with no informational content nevertheless increase market efficiency?
Problem 5
Intuition initially suggests that advertising should be heavier in more concentrated industries. Yet, oligopolies advertise more often than monopolies. Can you explain why?
Problem 6
Evidence suggests that the probability that a household will switch to a new brand of cereal rises as the brand is more intensively advertised. Yet, the effect of advertising is much lower for households that have already tried that brand. Does this suggest that the advertising is persuasive or informative?
Problem 7
Consider a market with two firms. 𝑞𝑞1 and 𝑞𝑞2 are the sales of the two firms, and 𝑎𝑎1 and 𝑎𝑎2 represent
the level of advertising by the two firms, respectively. The derivatives 𝑑𝑑𝑞𝑞1
𝑑𝑑𝑎𝑎2 and
𝑑𝑑𝑞𝑞2
