Asymmetric Information and. Limited Information about Price Tourists and Natives. Informed and Uninformed Customers. Few informed customers 11/6/2009

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1 symmetric Information and dvertising i Industrial Organization K. Graddy Limited Information about Price Tourists and Natives n Exlanation for Price Disersion ll firms ave identical costs Two tyes of consumers wit different searc costs: tourists andnativesnatives Natives are informed consumers wit zero searc costs Tourists are uninformed consumers wo ave searc costs of c. Natives buy only at low rice stores. αl consumers are informed and ( α)l consumers are uninformed. Eac consumer buys unit of te good as long as te rice is no iger tan u Tere are n firms Suose all firms set te same rice c (= to average cost) and tey equally sare sales Eac firm sells q c = L/n units of outut If a firm raises its rice to just above c it sells ( α)q c units. Informed and Uninformed Customers If > u ten zero sales If c < u ten it sells ( α)q c units If = c ten it sells q c units Te one rice equilibrium can be broken if and only if its revenues at te iger rice but lower volume, exceed its costs at te lower volume note tat at rice = c zero rofits are made. So, tere needs to be enoug uninformed customers! Few informed customers If te firm can raise its rice witout losing many customers, ten a two rice equilibrium can exist. Imlicitly define q a as te level of outut suc tat C(q a ) = u. Ten, it ays for a firm to deviate if ( α)q c > q a or α< q a /q c

2 Notes Tere cannot be an equilibrium in wic everyone carges above c because a firm could deviate and gain all of te informed customers. Likewise, i tere can only be a two rice equilibrium, not a 3 rice equilibrium te firm carging te middle rice would always make less tan if it carged te ig rice. If tere is a two rice equilibrium, te lowrice firms carge c and te ig rice firms carge u. Telser (964) Hardly any business ractice causes economists greater uneasiness tan advertising. mong te many reasons for tis feeling is te oinion eld by some economists tat cometition and advertising are incomatible. Nelson (974) Exerience goods: can only know by consuming Searc goods: can know from re urcase information Persuasive advertising canges eole s tastes Informative advertising tells customers tat te good exists dvertising and Welfare Two views of advertising: advertising informs and imroves welfare or advertising ersuades and reduces welfare. Informing about te existence of a roduct rice Suose monoolist wit rice and cost c and marginal demand D (additional demand te advertising creates) dvertising cost is Ten advertising creates a social surlus S Wit extra rofit gross social benefit is S+ Firm sets = for rofit maximization So net gain is S (a ositive externality on consumers) Imlies socially too little advertising c S D() demand 2

3 Business stealing effects roriability effects Butters odel (well known, but we aren t going to do) Otimal amount of advertising i noter View of dvertising Welfare cange is W= -q t te margin a rofit maximizing monoolist sets increase in rofit equal to increase in cost = Terefore, W=-q wic is negative If advertising increases rices tere is at te margin in equilibrium an unequivocal welfare loss: socially too muc advertising Oligooly: Droing te assumtion of monooly increases te incentive to advertise to steal business from rival firms. Te rivate gain to advertising increases but te social gain is uncanged leading to an even greater social excess of advertising. dvertising and te Price and Quality of Otometric Services (Kwoka, ER, 984) dvertising of otometric services ermitted in some US cities, not in oter Trained observers wit similar eye conditions made 47 visits to otometrists in tese cities. In cities were advertising ermitted, distinguised suliers wit (NONE): no advertising Suliers wit rominent dislays (STORE) (SLL) small advertisers (LRGE) large advertisers, e.g. cains Otometrists in advertising cities ad lower rices, te discount being larger te more te sulier advertised STORE, SLL, and LRGE sulied sligtly lower quality (as measured by time sent on te examination) on average, but not statistically significant NONE sulied very significantly iger quality ( to comete wit teir low rice advertising rivals in te market). Study suggests advertising increases elasticity of demand 2: dvertising Dorfman Steiner condition: monooly s rofit maximizing advertising and rice levels sould be set so tat te ratio of advertising exenditure to revenue equals te (absolute value of te) ratio of te advertising elasticity to rice elasticity. Formally, R Q 3

4 Proof etodology dvertising will be great in a market wit low demand elasticity. dvertising will be more intense te greater te market ower Does not mean tat advertising creates market ower Unless tere is a cange in demand tat alters te ratio of te two elasticities, /R ratio will be constant. Write down general definition of rice and advertising elasticity aximize rofits wit resect to rice and rofits wit resect to advertising Put bot FOC in terms of rice cost mark u and substitute in advertising quantities were aroriate Equate and ten rearrange Pr oof : Q (, ), were 0,0, and Q (, ) Q (, ) P and Q P Q Q cq c (, ) FOC( P) 0 ( ) c c c (, ) FOC( ):0 ( c) c EQUTE and RERRNGE! dvertising as a Signal of Quality (Klein and Leffler 98) New exerience good of uncertain quality to consumers: could be ig quality, or low quality l verage costs are C and C were C C l l. Te low quality good is cometitive so tat l Cl Once a firm as ceated tis is known to all consumers and will never again be able to carge > l If rice C, ten 0 and te ayoff to ceating is qc() q 0 l Consumers, knowing tis, will not ay for te good (Te Lemons roblem) Tere may, owever, be a rice iger tan te erfectly cometitive rice of ig quality outut if tis would ) motivate onest roduction of te iger quality good 2) not comletely dissaate consumers' surlus If rice > C a stream of rofits is made from selling, te resent value of wic may exceed te one-off gain from ceating. Firms cannot signal by rice wat sort of firm tey are, can tey signal in anoter way? Tese roblems avoided if firm makes sunk exenditures on advertising increasing costs to C Cometition will ensure tat firms advertise to te extent tat sunk costs equal te caital value of te remium rental stream wen ig quality is sulied at te quality- assuring rice. Costs are sunk as ceating would make brand wortless and terefore advertising costs are not recoverable Te advertising need not convey any information, excet tat it was costly b 4

5 Conclusion Economists ave clearly tougt a lot about advertising, but do tey understand it? 5