1 Information, Persuasion, and Signalling

Transcription

1 ECON 312: Advertising 1 We will now exmine nother strtegic vrible vilble to firms, tht of dvertising. Industril Orgniztion Advertising 1 Informtion, Persusion, nd Signlling 1.1 Persusion versus Informtion We cn ctegorize goods in reltion to dvertising into two ctegories tht would delinete the type of dvertising tht could be pursued, 1. Serch Goods re goods whose fetures or chrcteristics cn be scertined prior to consumption. Exmples of which re computers, nd crs. 2. Experience Goods re goods whose fetures nd chrcteristics cn only be scertined upon consumption. Exmples of which re wine, nd resturnt menus. Looking t the ctegoriztion, you should relize tht it ws done becuse the ssocited dvertising schemes or strtegies re or cn be different. Prticulrly, we cn distinguish the type of dvertising messges into, 1. Informtive Advertising which rely pertinent informtion bout product s existence, chrcteristics, nd sles conditions, nd/or 2. Persusive Advertising which is ment to chnge consumers perception or preference for the product. The principl reson for this distinction of dvertising messge is to llow us to exmine the vlue of dvertising to society, including both consumers nd the firms. To the lyperson, most would gree tht there is substnce, nd vlue in informtive dvertising, but little in persusive dvertising. Although intuitively plesing, it is not completely correct. If hving celebrity endorsement of firm s product does indeed rise sles nd mrket shre, then there is rel vlue to the firm. Of course tht nlysis ignores the vlue to the consumer, if the product is nothing but dud. Further,

2 ECON 312: Advertising 2 since their is full spectrum of products some of which re experience goods, it would seem the sole mens of getting consumers to try their product is through persusive dvertising. In fct, persusive dvertising is indirectly informtive. 1.2 Signlling Just becuse n dvertisement seems superficilly to be nothing but public chest beting session, does not preclude the ide tht there is some informtive content in there, besides of course the obvious fct tht celebrity might endorse it. To see this, first notice tht within ny prticulr segment of experience goods, such s Shirz wine in generl, or Greek resturnts within metropolitn city, there re differentil in qulity. Then if nything, we cn perceive multi-million dollr dvertising messge tht declres tht wine to be the best in the world, through perhps cmer pnning slowly towrds celebrity sipping on it, s direct messge tht the wine is relly the best, nd tht we should relly try it. The lterntive would of course be to let the rndom whims of consumer dictte when nd where they would try it. Within one shot gme scenrio, the firm would engge in persusive dvertising in its mrket if nd only if, 1. The mrket shre tht could be gined upon dvertising is greter thn the cost of production nd dvertising. 2. Tht the cost of dvertising is too high for their competition. However, if you think bout it, firm could lwys feign being producers of good products in one shot gme, stel the entire mrket, while producing low qulity product, nd thereby rise profits. If the dvertising cost for them is too high, it would likewise be too high for the firm tht is intent on mking good product, if we ssume, not unresonbly tht the better the qulity of product, the greter the cost of production. However, consider repeted gme mong producers of experience goods. Given tht consumers cn consume the product severl times over the lifetime of the good,

3 ECON 312: Advertising 3 there re now dditionl concerns to the firm mking the high qulity product. 1. Firstly, the sooner they cn persude the consumers to try their product, the sooner they would relize the qulity, nd continue consumption, nd thereby rising the lifetime profit of the firm. 2. They would do so if nd only if the cost of production of the high qulity good in ech period, nd the totl dvertising cost is less thn the gin in revenue, nd thereby rising profits. 3. Tht the cost of dvertising is to gret for low qulity firm to emulte (i.e. pretend to be high type), since now in considering lifetime profits, the low qulity firm would relize tht once consumers try their product they would never repet their consumption. So tht if the cost of production is higher then the gins from lying, they would not engge in emulting the high qulity firm. Only when this finl point is true re dvertising messges on qulity credible. Tken together in the repeted gme scenrio, persusive dvertising offers signlling mechnism to the consumers bout the qulity of their product. A seprting equilibrium, where consumers would be ble to tell high nd low qulity firms prt, consequently (indirectly) informtive in nture. 1.3 Advertising Intensity A wy in which we cn mesure the intensity of dvertising expenditure is with the Advertising-to-Revenues Rtio or T R while T R is the totl revenue of firm. where is totl dvertising expenditure, This would obviously differ mong firms depending on the type of product they mnufcture, nd the industry they belong to. The key ides re s follows pertining to the fctors tht ffect dvertising intensity. 1. The mrginl gin to dvertising is greter the more responsive demnd is to dvertising. This point is self explntory since it only mkes sense for the firms to dvertise more if they re ble to ffect demnd through

4 ECON 312: Advertising 4 their dvertising efforts. Digrmmticlly, this implies more dvertising expenditure the greter the shift in demnd s result of dvertising, s depicted below. Figure 1: Advertising Elsticity & Returns from Advertising p c q q s q l q 2. The mrginl gin to dvertising is greter the lrger is the price cost mrgin which in turn is function of the price elsticity of demnd. This point pertins to the mrginl gin from the dditionl unit of the product sold. The gins from selling n dditionl unit is greter the greter is the mrgin from the sle, which in turn is dependent on the elsticity of demnd tht the firm fces for it product. This then mens tht the greter is the mrgin from sle, the greter is the incentive to dvertise. This is depicted below where we hve two firms fcing two elsticities of demnd. Notice tht in equilibrium, the firm tht produces the sme level of output but fces more inelstic demnd, hs greter price-cost mrgin. Given the sme shift in quntity demnded, the profit gined from the shift is greter for the firm fcing the more inelstic demnd, nd consequently would hve greter incentive for dvertising.

5 ECON 312: Advertising 5 Figure 2: Demnd Elsticity & Returns from Advertising p c q The bove two point re succinctly summrize by the Dorfmn-Steiner Formul T R = p MC η = η p ɛ The condition cn be esily derived from firm s profit mximising choice. Let s ssume tht the inverse demnd function be dependent on the totl mount on totl quntity produced, q, nd totl mount of dvertising expenditure,, q(p, ). In ddition, ssume constnt mrginl cost, c. Then the profit function is, mx π = (p c)q(p, ) p, Then the optiml choice of dvertising is described by the following conditions, q p (p c) + q(p, ) = 0 ɛ p = 1 p c q (p c) = 1 η q(p, ) = 1 p c

6 ECON 312: Advertising 6 Combining the conditions, we obtin, q(p, ) η η ɛ = ɛ p = pq(p, ) = T R 1.4 Mrket Structure & Advertising Intensity We now sk the question regrding how does dvertising expenditure vry with the mrket structure, i.e. how does it vry with dvertising nd price elsticities? There re essentilly two issues we hve to consider here. 1. As we hve noted, the lower the price-cost mrgin, the lower the incentive for rising dvertising expenditure. 2. There is lso the problem of dvertising expenditure benefiting not only the firm tht spend itself, but spill-overs tht would be greter the greter the similrity between goods, which bsiclly encourges free riding. In tht sense, dvertising expenditure is public good. 3. On the other hnd, there is the direct effect tht dvertising expenditure rising consumer wreness of the firms product, thereby incresing demnd nd the mrket shre. Given the bove concerns we cn imgine then tht n industry chrcterized by lrge number of firms, possibly hving very similr goods would hve lrge price elsticity of demnd, nd consequently low price-cost mrgin, which bsed on our previous nlysis reduces the incentive for dvertising, i.e. the optiml level of dvertising expenditure is lower the lrger the number of firms, which is reinforced by the public good/free riding effect of dvertising in such industries. On the other hnd, the greter is concentrtion within mrket, the greter is the ownership over the effects of dvertising, which would rise own mrket shre, thereby rising dvertising expenditure. Therefore s the number of firms in n industry increses, nd industry concentrtion decreses, ech 1. firm s mrgin decreses, 2. ech firm cptures less of the

7 ECON 312: Advertising 7 demnd incresing effect of dvertising (free riding problem), thereby decresing dvertising expenditure. But 3. t the sme time, there is greter incentive to ttempt t cpturing the demnd shifting effect of dvertising. The net effect s you my imgine is mbiguous. Empiriclly, there is some consistency in tht, s concentrtion decreses from high level, dvertising intensity increses; nd strting from low level of concentrtion, dvertising intensity decreses s concentrtion decreses. 2 Price Competition nd Advertising The bove discussion hs precluded concerns tht dvertising expenditure like price nd quntity choices re in fct strtegic choices tht re vilble to the firms. Consider possible mnner in which two firms my interct with one nother through strtegic choices in dvertising. Let the demnd be constnt, nd ssume tht prices re likewise fixed in this exmple. Here dvertising hs no other purpose thn to secure greter mrket shre, of course ssuming rising dvertising rises mrket shre. Then the incentive of ech firm is lwys to undercut its competitor in dvertising expenditure s long s there re dditionl gin, such tht on the limit, firms would totlly expend the mrgin on dvertising. In this simple exmple here, the outcome in the use of dvertisement is s in Bertrnd price competition, nd is rther extreme, nd typicl strtegic interction in dvertising choice is not tht severe. Just s in price competition, the severity of competition cn be verted through repeted interction between firms. However, there re distinct fetures bout dvertising tht mkes coopertion difficult. Firstly, unlike pricing strtegies, the frequency with which dvertising strtegies re chnged is low. Secondly, the effect of dvertising hs longer run effect. Both these resons, if you would recll mkes collusive equilibrium difficult. This then implies we should expect to see fr greter expenditures on dvertising thn is optiml. Unlike price nd quntity which re not mutully exclusive choices since once one is determined, so is the other, dvertising is quite prt from those strtegic choices, which suggests tht we might wish to consider the effect this choices, between the levels of price/quntity nd dvertising, hve on ech other.

8 ECON 312: Advertising Advertising Softens Price Competition Generlly, dvertising product chrcteristics increses product differentition nd softens competition. Consider simple exmple where two firms operte within mrket, nd both of them produce differentited products from ech other. However, the consumers in the mrket do not hve complete informtion, nd insted think of the two products produced s the sme for ll intents nd purpose. Without dvertising, nd ssuming tht firms cn only compete on prices, we would end up with Bertrnd Competition outcome. However, if firms use dvertising s mnner in which to inform consumers of the true merits or differences, then they re ble to crete their own demnd, nd bsed on our nlysis of the Hotelling Model, we know tht when firms re perceived s different, they re ble to price bove the mrginl cost, i.e. dvertising increses product differentition nd softens competition. However, common perception is tht dvertising cretes rtificil differentil, tht my not exist or is hrdly ny substnce (which is interesting since if the differentil is of no substnce, why would consumers perceive the product s different), which leds to the rgument tht dvertising is wsteful, nticompetitive nd hrmful. To economists, this ccustions re hrd to quntify, since how cn we exmine socil welfre which is bsed on consumer welfre when the im of dvertising is to chnge preferences! 2.2 Advertising Intensifies Price Competition We will now consider the dimetric wy in which prices nd dvertising expenditure might interct. Consider mrket consisting of two firms producing the sme product. Consumers re not wre of the prices set, but re willing to py mximum (willingness to py) of p mx. Assume tht the cost of serching exhustively is exorbitnt. Then the best strtegy vilble to the consumer is to rndomly pick firm, check the price, nd purchse it if the price is t or below her willingness to py. Knowing this, the firms best response would be to price t p mx. However, if the sme industry were to begin to engge in dvertising of prices, price competition will increse. Wht this would do in this industry is s we

9 ECON 312: Advertising 9 discussed t the beginning of this section, where dvertising competition would drive mrgins for the firms down to zero. Note tht price will still be bove the mrginl cost of production, but in equilibrium profits re still zero. Why? If dvertising is detrimentl, why do firms dvertise prices?