Industrial Organization 05: Advertising

Industrial Organization 05
Advertising
Marc Bourreau
Telecom ParisTech
Marc Bourreau (TPT) Lecture 05: Advertising 1 / 26

Outline
1 Definition of informative and persuasive advertising

2 Examples measuring advertising intensity by sector
3 Advertising spending by a monopoly
4 Effects of advertising on competition

Informative and Persuasive Advertising
Information and Persuasion
We distinguish two types of goods (Nelson, 1970 and 1974):

"Research goods"
"Experience goods"
Research goods
Goods whose quality can be certified before purchase.
Experience goods
Goods whose quality characteristics cannot be observed before purchase (or it
would be too costly).

According to Nelson, the nature of an "experience good" depends on the cost

for a consumer to research information on the product quality.
We distinguish two types of information:

Hard information: existence of the product, its price, the retailers distribut-
ing it, its characteristics (direct information).
Soft information: indirect information.

The distinction between research goods and experience goods leads to distin-
guish two types of advertising:
Informative advertising
Persuasive advertising
Informative advertising
Provides information on the product characteristics, to reveal an objective dif-
ferentiation.
Persuasive advertising
Seeks to modify consumers preferences, to create a subjective differentiation.

Which form of advertising is the most common?
→ The ratio advertising to sales is 3 times superior for experience goods than
for research goods (according to Nelson, 1976).
What is a priori the difference between informative advertising and persuasive

advertising in terms of social welfare?
Informative advertising: some value a priori

Persuasive advertising: value less clear

For example, we have studied the impact of advertising on "Yoplait 150", intro-
duced in the US in 1987.
The data (sales, advertising) have shown that
The probability of purchasing Yoplait 150 = 1,85 x advertising exposition

- 0,24 x advertising exposition x number of previous purchases + (other
control variables).
Where advertising exposition = number of 30-seconds ads watched by the

consumer within a week.
→ Consistent with the idea of informative advertising.

In 1984, The American Congress has implemented an accelerated authorization

process for generic drugs.
Between 1984 and 1998, their market share has varied from 18% to 42%.
And yet, the branded drug price hasn’t decreased, on the contrary, it has
increased.
This is explained, in particular, by the intensive advertising campaigns con-

ducted by the labs distributing these branded drugs.
→ Consistent with the idea of pervasive advertising.

Advertising as a Signal
For experience goods it could be difficult to make informative advertising.
Nonetheless, advertising can act as a signal send to consumers to indicate that

quality is high.
Let’s assume that there are low quality (experience) goods and high quality
goods and that the purchases are repeated.
High-quality providers can have incentives to spend a large amount of money

in advertising to signal themselves as providers of high-quality goods.

Advertising as a Signal
Idea: It is only rational to spend a lot if the firm offers a high-quality product.
Conditions for this strategy to be credible?
→ A high quality firm should have a higher interest in making consumers try
its product than low quality firms.
Is this type of advertising a waste?
→ Not necessarily, the equilibrium with advertising could be more efficient

than the equilibrium without.

Intensity of Advertising for a Monopoly
Advertising Spendings Intensity
We observe that the ration of advertising on sales (or turnover) varies between
industries:
Salt: 0 to 0.5%
Breakfast cereals: 8 to 13%
A simple formula (the Dorfman-Steiner formula) provides an explanation:
a p − C0 η
= η=
R p
where
η denotes the advertising spending elasticity of demand
denotes the elasticity of demand
a the advertising investments
R the revenues

Let’s consider a monopoly firm.
The demand function is q = D p, a .

The monopoly maximizes its profit

pD p, a − C D p, a − a,
with respect to p and a.
The first order conditions are:
D p, a + pDp p, a = C0 D p, a Dp p, a ,

and
pDa p, a = C0 D p, a Da p, a + 1.


The first FOC is given by
D p, a + pDp p, a = C0 D p, a Dp p, a ,

If we denote
pDp p, a
ε=− ,
D p, a
we find the inverse price elasticity rule:
p − C0 1
= .
p

The second FOC is
pDa p, a = C0 D p, a Da p, a + 1,

with
p − C0 Da = 1.

We define:
aDa p, a
η=
D p, a
so
D p, a
Da p, a = η ,

a
and
p − C0 ηD p, a = a.



We have
p − C0 ηD p, a = a.

therefore
p − C0 η

a a
η= = = .
p pD p, a R
Conclusion:
For the monopoly, the optimal ratio between Advertising spending and
turnover is equal to the relation of the elasticity of demands with respect to the
Advertising and the price.


Some examples (according to Metwally, 1975):
Instant coffee: η/ = 0, 019 and a/R = 0, 020
Bottles of beer: η/ = 0, 008 and a/R = 0, 011
Cigarettes: η/ = 0, 019 and a/R = 0, 046
Soap: η/ = 0, 013 and a/R = 0, 012
Washing powder: η/ = 0, 019 and a/R = 0, 030
Toothpaste: η/ = 0, 024 and a/R = 0, 059
Engine oil: η/ = 0, 017 and a/R = 0, 016

Dorfman-Steiner formula:
a η
=
R
We can apply the D-S formula to get an intuition on the effect of the market
structure on advertising spending.
How does the firm’s price elasticity vary in function of the number of competi-
tors?
→ It tends to increase.
→ And therefore the advertising intensity tends to decrease.

What is the effect of an increase in the number of firms on η ?

If advertising is a public good? = the advertising increases each firm’s demand
→ Therefore, the elasticity of adver-

tising (and as such the advertising in-
tensity) decreases with the number of
firms.


If, on the contrary, the only effect of advertising is to make consumers switch
from a firm to another?
→ A priori, the elasticity of advertising (and as such the advertising intensity)
can increase with the number of firms (the incitations to capture competitors’
market increases with the number of competitors).

This analysis suggests an ambiguous relationship between the intensity of

advertising spending and the number of firms.
Empirical studies suggest that:

Starting with a small number of firms: increasing the number of firms will
increase advertising intensity
Starting with a large number of firms: increasing the number of firms will
decrease advertising intensity

Effects of Advertising on Competition
Price Competition and Advertising
General intuition
Advertising is an instrument of competition, like prices.
For example, what would happen if the only effect of advertising were to shift
market shares?
→ We would have a mechanism "à la Bertrand": increase of advertising spend-

ing until the profits reach zero.
But advertising expenses differ from prices:

Interactions are less frequent
Advertising is an investment and may have long-term effects

Advertising Can Soften Price Competition
Let’s assume a competitive framework à la Hotelling (linear differentiation)

The two firms are located at the two extremes of the varieties interval
The consumers are uniformly distributed on the interval
But we assume that they ignore the differences between the goods of the
two firms
What happens? → we have a competition "à la Bertrand" and therefore

the firms obtain zero profits
If firms can make informative advertising, what happens? → We have

a competition "à la Hotelling" and therefore firms make strictly positive
profits.
Conclusion: Informative advertising can increase the differentiation and de-

crease the intensity of price competition.

Advertising Can Strengthen Price Competition
Two firms sell homogeneous (identical) goods

Consumers are willing to pay v for the good
But they ignore the existence and the prices of firms, they have to carry
out a research step
Let’s suppose they can only make one research
What is the equilibrium price? → the equilibrium price is p = v
If firms can make informative Advertising, what happens? → the equilib-

rium price is p = c
Conclusion: Informative advertising can increase the intensity of price compe-

tition.

Advertising as an Entry Barrier
Theory of John Sutton (1991)

In markets where it is possible to differentiate in the eyes of consumers, we
observe important advertising spending levels and a high degree of concentra-
tion.
→ Advertising as an entry barrier.

Advertising as an Entry Barrier

RealLemon example (1978), lemon juice brand:
The brand RealLemon of Borden dominated the US markets for several
years
Entry of a competitor Golden Crown, with an identical good
But intensive advertising campaigns from RealLemon → GC had to set a
price 15 to 25% lower
Leading to a price war
Complaint against Borden in front of the FTC which concluded on a abuse
of dominant position from Borden (complaint withdrawn in appeal)

Take-Aways
Take-Aways
There are two types of advertising: informative advertising (provides

information on product characteristics) and persuasive advertising (seeks
to create a subjective differentiation).
The monopoly invests in advertising such that the ratio of its spending on
its turnover is equal to the ratio of the demand elasticity to advertising on
the price elasticity of demand.
Advertising on product characteristics tends to soften competition, as it
increases the possibility of differentiation for firms.
Advertising on prices tends to increase price competition.

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Industrial Organization 05

Marc Bourreau (TPT) Lecture 05: Advertising 1 / 26

1 Definition of informative and persuasive advertising

Marc Bourreau (TPT) Lecture 05: Advertising 2 / 26

Information and Persuasion

We distinguish two types of goods (Nelson, 1970 and 1974):

Marc Bourreau (TPT) Lecture 05: Advertising 3 / 26

Information and Persuasion

According to Nelson, the nature of an "experience good" depends on the cost

We distinguish two types of information:

Marc Bourreau (TPT) Lecture 05: Advertising 4 / 26

Information and Persuasion

Marc Bourreau (TPT) Lecture 05: Advertising 5 / 26

Information and Persuasion

Which form of advertising is the most common?

What is a priori the difference between informative advertising and persuasive

Informative advertising: some value a priori

Marc Bourreau (TPT) Lecture 05: Advertising 6 / 26

Information and Persuasion

The data (sales, advertising) have shown that

The probability of purchasing Yoplait 150 = 1,85 x advertising exposition

Where advertising exposition = number of 30-seconds ads watched by the

→ Consistent with the idea of informative advertising.

Marc Bourreau (TPT) Lecture 05: Advertising 7 / 26

Information and Persuasion

In 1984, The American Congress has implemented an accelerated authorization

This is explained, in particular, by the intensive advertising campaigns con-

→ Consistent with the idea of pervasive advertising.

Marc Bourreau (TPT) Lecture 05: Advertising 8 / 26

For experience goods it could be difficult to make informative advertising.

Nonetheless, advertising can act as a signal send to consumers to indicate that

High-quality providers can have incentives to spend a large amount of money

Marc Bourreau (TPT) Lecture 05: Advertising 9 / 26

Conditions for this strategy to be credible?

Is this type of advertising a waste?

→ Not necessarily, the equilibrium with advertising could be more efficient

Marc Bourreau (TPT) Lecture 05: Advertising 10 / 26

Advertising Spendings Intensity

A simple formula (the Dorfman-Steiner formula) provides an explanation:

Marc Bourreau (TPT) Lecture 05: Advertising 11 / 26

Advertising Spendings Intensity

Let’s consider a monopoly firm.

The demand function is q = D p, a .

The monopoly maximizes its profit

with respect to p and a.

The first order conditions are:

Marc Bourreau (TPT) Lecture 05: Advertising 12 / 26

Advertising Spendings Intensity

The first FOC is given by

we find the inverse price elasticity rule:

Marc Bourreau (TPT) Lecture 05: Advertising 13 / 26

Advertising Spendings Intensity

The second FOC is

Marc Bourreau (TPT) Lecture 05: Advertising 14 / 26

Advertising Spendings Intensity

Marc Bourreau (TPT) Lecture 05: Advertising 15 / 26

Advertising Spendings Intensity

Marc Bourreau (TPT) Lecture 05: Advertising 16 / 26

Advertising Spendings Intensity

Marc Bourreau (TPT) Lecture 05: Advertising 17 / 26

Advertising Spendings Intensity

What is the effect of an increase in the number of firms on η ?