3Advertising 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 doesP=P(Q, A)Recall, the Lerner Index, LIL = (p - MC)/p = 1/|EP|Where |EP| is the price elasticity of demand
4Advertising and Monopoly Power The elasticity of output demand with respect to advertising A is defined asWe can derive the following relationship:= Advertising/sales ratioDorfman-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.
5Intuition behind D-SRecall: 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.
6Dorfman-SteinerThe Dorfman-Steiner formula relates the advertising-to-revenues ratio to price-cost margin and ADVERTISING 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).
7ExampleSuppose you have been hired to market a new music recording that is expected to have target sales of $20 million for upcoming yearThe marketing department has estimated that 1% increase in advertising will translate to 0.5% increase in salesAnd that 1% increase in the price of the recording would reduce the number sold by about 2%How much money should you commit to advertising the recording in the coming year?
8Advertising to Sales Ratios This ratio varies between industries.salt industry: a-s-r = 0 to .5%breakfast cereals industry: a-s-r= 8% to 13%Advertising intensity depends on:the type of product.advertising elasticity of demandprice elasticity of demand
11Advertising and Monopoly Power The Dorfman-Steiner Condition is the starting point for thinking about the relationship between advertising and market power. It yields several important insightsRecall that the Lerner Index LI=(P – c)/P =1/|ED|Hence, we can write the Dorfman-Steiner condition as:Advertising-to-Sales Ratio = EALIThe observed positive correlation between advertising intensity and market powerIndustries with high responsiveness of sales to advertising (high EA) will have high advertising intensityAdvertising similarity across industries and over time is to be expected if EA and ED are similar
12Ad 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.
13Advertising 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.
14Advertising and PriceAdvertising can increase price competition when firms advertise about their prices.If prices were artificially high due to imperfect price information, then firms have an incentive to advertise about their prices to attract more consumers.Rival firms will soon follow suit and advertise about their prices. This leads to higher expenditures on advertising and lower prices.Advertising in this case strengthens competition due to heightened awareness of prices.
15Supply Side: Combative advertising Combative advertising, a characteristic of mature markets, is defined as advertising that shifts consumer preferences towards the advertising firm, but does not expand the category demand.Not about influencing the consumer preferences, but rather about the supply side and advertisingRedistributes consumers among brands. If the real differences between brands are modest, then combative advertising may be excessive.Basis of Prisoner's dilemma in advertising.
16Advertising Wars The prisoner's dilemma applies to advertising All firms advertising tends to equalize the effectsEveryone would gain if no one advertisedAdvertising Wars Two firms spend millions on TV ads to steal business from each other. Each firm’s ad cancels out the effects of the other, and both firms’ profits fall by the cost of the ads.
17Cigarette Advertising on TV All US tobacco companies advertised heavily on TVSurgeon General issues official warningCigarette smoking may be hazardousCigarette companies fear lawsuitsGovernment may recover healthcare costsCompanies strike agreementCarry the warning label and cease TV advertising in exchange for immunity from federal lawsuits.19641970
18Cigarette Advertising After the 1970 agreement:Cigarette advertising decreased by $63 millionIndustry Profits rose by $91 millionPrisoner’s DilemmaAn equilibrium is NOT necessarily efficientPlayers can be forced to accept mutually bad outcomesBad to be playing a prisoner’s dilemma, but good to make others play
19Strategic Interaction Players: Reynolds and Philip MorrisStrategies: Advertise or Not AdvertisePayoffs: Companies’ ProfitsStrategic Landscape:Each firm earns $50 million from its customersAdvertising costs a firm $20 millionAdvertising captures $30 million from competitorHow to represent this game?
20Representing a Game PLAYERS Philip Morris No Ad Ad Reynolds 50 , 50 20 , 6060 , 2030 , 30STRATEGIESPAYOFFS
21What to Do? Philip Morris No Ad Ad Reynolds 50 , 50 20 , 60 60 , 20 30 , 30If you are advising Reynolds, what strategy do you recommend?
22Solving the Game Philip Morris No Ad Ad Reynolds 50 , 50 20 , 60 60 , 2030 , 30Best reply for Reynolds:If Philip Morris advertises:If Philip Morris does not advertise:
23Prisoner’s Dilemma Optimal No Ad Ad 50 , 50 20 , 60 60 , 20 30 , 30 EquilibriumBoth players have a dominant strategyThe equilibrium results in lower payoffs for each player
27Persuasive Advetising The persuasive view holds that advertising alters consumers' tastes and creates spurious product differentiationThe demand for a firm's product becomes more inelasticAdvertising 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.
28Model of Advertising and Crowd Appeal $QuantityMCDemand without advertising*Demand with advertisingProfit
29Model of Persuasive Advertising Increase in consumers’ willingness to pay is a function of the amount spend on advertising.As s increases, WTP increases, as does consumer demand and profit.Firms will select the level of advertising that maximizes profit, i.e., the level of advertising where the marginal revenue from ads is equal to the marginal cost of ads.
30Complementary 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
31Complementary 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.
32Complementary View An implication is that: 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.Component of most luxury goods marketing.
33Mission Statement“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.”
35Informative ViewAdvertising 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
36Model of Advertising as Information $QuantityMCDemand with low advertisingDemand with high advertisingProfit
37Model 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.