# AEM 4550: Economics of Advertising Prof. Jura Liaukonyte LECTURE 4 & 5: PRODUCT DIFFERENTIATION AND PERSUASIVE ADVERTISING.

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AEM 4550: Economics of Advertising Prof. Jura Liaukonyte LECTURE 4 & 5: PRODUCT DIFFERENTIATION AND PERSUASIVE ADVERTISING

Lecture Plan  Superbowl Ads  LI and Dorfman Steiner revisited  Product differentiation and advertising  Taxonomy of product attributes  Search  Experience  Credence  Taxonomy of advertising types  Persuasive Advertising  PBS Frontline: Persuaders

Super Bowl Ads  The 21 most-watched television programs in American history are all Super Bowls  Super Bowl 2016 delivered its 3 rd highest overnight TV rating ever  112.2MM viewers in 2014  114.4MM viewers in 2015  111.9MM viewers in 2016  Cost of exposure in 2015, \$5 million for a 30-second spot  Average CPM on TV for 2016 = \$44.68 (up from \$37.35 from last year).  CPM – Cost per Mille - price an advertiser pays to reach a thousand viewers  [Calculate CPM for a 2016 Superbowl ad = 5*1000/111.9 = \$39.3

Lerner Index DefinitionFormula  Measures the market power of a company based on the price it can charge  The higher the number, the more pricing power the firm has  Mark-up power reflects monopoly power  PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark-up will increase. L = (p - MC)/p = 1/|E P |

Advertising and Monopoly Power  Assume a firm faces a downward-sloping demand inverse curve but one that shifts depending on the amount of advertising A that the firm does  P=P(Q, A) Recall, the Lerner Index, LI Where |E P | is the price elasticity of demand L = (p - MC)/p = 1/|E P |

Advertising and Monopoly Power  The elasticity of output demand with respect to advertising  A = Advertising/sales ratio Dorfman-Steiner Condition For a profit-maximizing monopolist, the advertising-to- sales ratio is equal to the ratio of the elasticity of demand with respect to advertising relative to the elasticity of demand with respect to price.

Intuition Behind D-S  Recall: the greater the demand elasticity, the lower the optimal price.  Price-cost margin is smaller when elasticity is higher.  Since the price-cost margin is smaller with elastic demand, the gain from advertising is also smaller even if the increase in quantity demanded is the same.  The marginal gain from advertising is greater the greater the price-cost margin.

Dorfman-Steiner  The Dorfman-Steiner formula relates the advertising-to- revenues ratio to price-cost margin and elasticity.  The advertising-to-sales ratio is greater the greater the advertising elasticity of demand and lower the price elasticity of demand (or the greater the price-cost margin).

Industry Concentration Four-Firm Concentration Ratio The sum of the market shares of the top four firms in the defined industry. Letting S i denote sales for firm i and S T denote total industry sales Herfindahl-Hirschman Index (HHI) The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000  S w i 2, where w i = S i /S T.

Measure of concentration 1 25 1 25 2 25 2 25 3 25 3 25 4 5 4 5 5 5 5 5 6 5 6 5 7 5 7 5 8 5 8 5 625 625 625 25 25 25 25 25 Concentration Index Firm Rank Market Share (%) Squared Market Share

125625 225625 325625 4525 55 65 75 85 Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ Measure of concentration CR 4 = 80 H = 2,000

HHI  The Herfindahl-Hirschman Index – the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50) Definition Properties Example In perfect competition, the HHI is small In monopoly, the HHI is 10,000 (100 squared) A popular measure with the Justice Dept in the 1980’s HHI < 1000 characterized competitive markets HHI > 1800 would bring Justice Dept challenge to proposed mergers E.g. The cigarette industry is highly concentrated with only 8 firms and a Herfindahl-Hirschman Index (HH1) of 2623

 All Credit Lending Institutions with their own card  27.2%J.P. Morgan Chase & Co.  19.2% Bank of America Corporation  18.9% Citigroup Inc.  17.2% American Express Company  4.0% Capital One  CR4: 83.2  HHI: 1810-1850  Total Number of Companies: 192 Market Definition

Ad Elasticity and Concentration  Each firm’s advertising elasticity decreases as concentration decreases.  The more fragmented the industry is, the lower the benefit from advertising that is captured by the firm that pays for it.  With more firms in the industry, a firm’s "split of the pie" is smaller. 1 2 3

Example: Credit Card Industry

Industry Average is 7.6% and has grown over the last few years Advertising to Sales Ratios

Example: Airline Industry

 High or low?  Transportation/Travel industry =1.9  Consumer Products, Books, PayTv, Communications, all > 5

Stylized Facts About Advertising  Volume of advertising expenditures is large. For the US, advertising expenditures total to over 2% of GDP  Underneath this national total is a wide variety in firm advertising behavior  Car makers (e.g., GM) and household product firms (e.g., Proctor & Gamble) spend the most on advertising  Basic patterns that emerge are:  Correlation between advertising & market power  Consistency of advertising behavior within industries—big advertisers remain big over time and across countries Facts Patterns

Worldwide Ad Spending by Region (2013)

Advertising by Media in the US

TOP 10 Brands in 2012

Product Differentiation  Products are different if there is some objective characteristic or property, real or perceived, that provides a basis for buyers to choose one over the other.  Product differentiation may lead to reduced own -price elasticity. As the degree of differentiation increases, the price elasticity will decrease. Definition Variation Strategy   Product Brand   Packaging   Condition of Sale   Service Provided   Location   Product Differentiation as an Entry Strategy   Product differentiation to create a niche market.   Product differentiation to deter entry.

Advertising and Product Differentiation  Advertising product characteristics increases product differentiation.  Consumers are more informed about objective product differences.  Firms can create some sort of subjective product difference.  Advertising in this case softens competition due to heightened awareness of product differentiation.  Soften competition: the industry is less competitive and firms have more market power.  Strengthen competition: the industry is more competitive and firms have less market power.  Firms are able to avoid Bertrand competition by advertising.

Perceptual Maps

Perceptual Map: Credit Cards

SelectivityAccessibility AmericanExpress Chase Citi B of A Uniformity Variety

Product Positions in Characteristics Space What could advertising do to change these positions? Are perceived and real characteristics the same thing?

Taxonomy of Products and Their Attributes

Understanding Customer  Determine prior to purchasing the goods and/or services.  Like color, price, freshness, style, fit, feel, hardness, and smell.  Examples: supermarket food, furniture, clothing, automobiles, and houses are high in search attributes. Search Attributes Experience AttributesCredence Attributes   Can be discerned only after purchase or during consumption or use.   Examples: Friendliness, taste, wearability, fun, and customer satisfaction.   Any aspects of a good or service that the customer must believe in   But cannot personally evaluate even after purchase and consumption.   Examples: the expertise of a surgeon or mechanic, the knowledge of a tax advisor, or the accuracy of tax preparation software.

Key Point  Firm (Brand) Reputation is more important for experience goods than search goods and most important for credence goods.  Has implications on advertising effects on demand.

Product Attributes Product Attributes Most Goods High in search attributes High in experience attributes High in credence attributes Difficult to evaluate Easy Most Services ClothingChair Motor vehicle Foods Restaurant meals Lawn fertilizer HaircutEntertainment Computer repair Education Legal services Complex surgery

How the Internet affects …  Search goods:  Can facilitate consumers' ability to obtain attribute information.  Experience goods:  Difficult to provide enough experience for consumers to assess the benefits of the product  Offline trial & Online purchase  Credence goods:  How to help consumers form a set of beliefs about the quality of the product?  Access to other people's beliefs about the quality of the product such as product testimonials

Advertising Taxonomy  Why do consumers respond to advertising?  An economic theory of advertising can proceed only after this question is confronted.  As economists have struggled with this question, 3-4 views have emerged, with each view in turn being associated with distinct positive and normative implications.

Main Views of Advertising  Persuasive  Informative  Complimentary  Memory Jamming (Reminder)

Life Cycle of Product

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Persuasive Advetising  The persuasive view holds that advertising alters consumers' tastes and creates spurious product differentiation  The demand for a firm's product becomes more inelastic  Advertising results in higher prices.  Such advertising by established firms may give rise to a barrier to entry, which is naturally more severe when there are economies of scale in production and/or advertising differentiation and brand loyalty.

Persuasive Advertising and Product Types  Recall, reputation is more important for experience goods than search goods and most important for credence goods.  Reputation and Persuasion are close synonyms in this case.  Among which type of products will we observe high levels of persuasive advertising?  Search, Experience or Credence?

The Pervasiveness of Persuasion  The average person is exposed to 300-400 persuasive messages per day from the media alone (Rosseli, Skelly, & Mackie, 1995)  The average person is exposed to 1,000 commercials per week (Berger, 2004)  An average of \$800 per person is spent on advertising in the U.S. each year (Berger, 2004)

Obvious Forms of Persuasion  A 30 second spot for Super Bowl costs \$5 million for a 30 second spot.  Product placements in movies and TV amounted to \$2.5 billion in 2005 (PQ Media).  Morgan (2005) “between 15- 30 products are inserted in every half hour of television programming”. Product Placement on American Idol

Product Placement http://www.brandchannel.com/brandcameo_films.asp Featured Brands: Apple, Bell, Cadillac, Chock Full O’Nuts, Chrysler, Cisco, Ford, Ford Mustang, Hill-Rom, HP, Lacoste, Listerine, Los Angeles Dodgers, Mercedes, Motorola, Pepsi, Philips, Pontiac, Pyrotect, Rolls Royce, San Francisco Giants, Sharp, The North Face, The Riviera Hotel and Casino, Timberland, Toyota, United States Parachute AssociationAppleBellCadillacChock Full O’NutsChryslerCiscoFordFord MustangHill-RomHP LacosteListerineLos Angeles DodgersMercedes MotorolaPepsiPhilipsPontiacPyrotectRolls RoyceSan Francisco GiantsSharpThe North FaceThe Riviera Hotel and CasinoTimberlandToyotaUnited States Parachute Association Featured brands: Apple, Belstaff, BMW, Citibank, Datascope, Ford, Ford Mustang, Hamilton, Honda, Hummer, JVC, Kleenex, Loews, Magnavox, McDonald's, MetLife, Mobil, Nautilus, NBC, Nissan, Panasonic, Ronzoni, Salvatore Ferragamo, Sbarro, Spam, Staples, Tic Tac, Time, Verizon, Viking, XM Satellite RadioAppleBelstaffBMWCitibank DatascopeFordFord MustangHamiltonHonda HummerJVCKleenexLoewsMagnavoxMcDonald's MetLifeMobilNautilusNBCNissanPanasonic RonzoniSalvatore FerragamoSbarroSpamStaplesTic TacTimeVerizonVikingXM Satellite Radio

Model of Persuasive Advertising  Total of N consumers in the market.  Each consumer will buy only one unit of the primary good.  Each consumer has a different value, v i, for the primary good.  Advertising increases each consumer’s value by the same factor, , regardless of their initial value. Thus each consumer’s value with advertising is  * v i.

Model of Advertising and Crowd Appeal \$Quantity  MC Demand without advertising Profit **** Demand with advertising

Model of Persuasive Advertising  Increase in consumers’ willingness to pay, , is a function of the amount spend on advertising, s.  As s increases,  (s) increases, as does consumer demand and profit.  Firms will select the level of advertising that maximizes profit, i.e., the level of s where the marginal revenue from s is equal to the marginal cost of s.

Model of Persuasive Advertising  In this model, higher levels of advertising lead to higher prices because the advertising increases the consumers’ willingness to pay.  Also, advertising can increase consumer surplus as well as firm profit, since advertising increases a consumer’s value.

Complementary View  Consumers possess stable preferences  Advertising directly enters these preferences in a manner that is complementary to the consumption of the advertised product  Advertising may contain information and influence consumer behavior for that reason  The consumer may value “social prestige” that is created by advertising

Complementary vs. Persuasive  The lines between complementary and persuasive are blurred, because it is hard to know whether ads change preferences or are part of consumer’s utility.

Complementary View  Associated with the Chicago School  When a firm advertises more, its product becomes more attractive to the consumer  “The household is made to believe – correctly or incorrectly – that it gets a greater utility of the commodity from a given input of the advertised product”  Consumer may value social prestige and advertising thus positions the product so that its consumption provides social prestige Definition Implication   Firms may compete in the same commodity (e.g., prestige) market even though they produce different market goods (e.g., jewelry and fashion) and advertise at different levels.

“Louis Vuitton must continue to be synonymous with both elegance and creativity. Our products, and the cultural values they embody, blend tradition and innovation, and kindle dream and fantasy.” Mission Statement

Price  Premium Pricing  Luxury image  Selling Point  Never on sale!!  Price range:  Handbags: \$550 - \$3,700++  Wallets: \$200 - \$700++

LVMH Moët Hennessy Louis Vuitton French holding company and one of the world's largest luxury goods conglomerate.

Mass-Commercialization of Luxury  Many luxury handbags are mass-produced in China.  The average markup for a luxury handbag is ten to 12 times production cost (marginal cost!).  Louis Vuitton's markup is up to 13 times production cost.  Family-owned companies that used to create exquisite bags, shoes and clothes, have been taken over by multi-billion dollar conglomerates.

Luxury Markets  Asia is now the biggest market for luxury brands  Strange? the U.S. and Europe are wealthier (per capita)  Luxury market in Japan is most alive:  40 % of all Japanese own a Vuitton item  Why such a global discrepancy?

Example: Credit Card Industry

Complementary Advertising American Express Ranked #1 most trusted company 24th best global brand Targets consumers with \$100,000 to \$1 million annual income Consumers see card as a luxury Gold Card, Platinum Card Other companies are competing with "metallic" or "gem" cards

Informative View  Advertising is attractive to firms as a means through which they may convey information to consumers.  Advertising effectively reduces consumers' search costs, since it conveys information about products.  Advertising may have pro-competitive consequences.  Advertising is a valuable source of information for consumers that results in a reduction in price dispersion  “Chicago School” view.

Model of Advertising as Information  Total of N identical consumers in the market.  Each consumer will buy Q(P) if informed about the product.  Advertising informs consumers about the existence and/or usefulness of the product.  Number of consumers informed depends on the amount spent on advertising.

Model of Advertising as Information  As ad expenditures increase, so does demand and profit.  Firms select advertising to maximize profit, i.e., where MR from ads is equal to the MC of ads.  In this model, higher levels of advertising do not lead to higher prices.  Advertising does increase total consumer surplus as well as firm profit, since advertising increases the number of consumers that get a surplus.

Empirical evidence: Setting  In the 1960s, considerable variation existed across US with respect to the legal treatment of advertising in the eyeglass industry  Some states prohibited all advertising  Some states prohibited price advertising but allowed non-price advertising  Some states had no restrictions  This variation provides a natural experiment

Empirical Evidence:  Eyeglass prices were substantially higher in states that prohibited all advertising than in states that had no restrictions  The association between price advertising and lower prices is striking and directly supports the informative view

Other Studies  Cady (1976) considers the U.S. retail market for prescription drugs in 1970  Retail prices are significantly and positively related to advertising restrictions  Maurizi and Kelly (1978) compare retail gasoline prices across major cities  Both the mean and variance of prices are lower in states where price advertising is allowed  Schroeter, Smith and Cox (1987) use survey data for the routine legal service market in 17 U.S. metropolitan areas  Evidence that price–cost ratios are lower when area-wide advertising intensity is greater  These studies all support the informative view

Comparison  Higher advertising leads to higher demand for each consumer, which leads to higher prices. Persuasive/Complementary ModelInformative Model   Higher levels of advertising leads to more consumers but not a higher demand for each consumer, so prices are not affected by advertising levels.