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

3. Lecture Plan 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

4. Lerner Index Definition Formula
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/|EP| 81

5. 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
L = (p - MC)/p = 1/|EP|
Where |EP| is the price elasticity of demand

6. 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.

7. 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.

8. 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).

9. Example
Suppose you have been hired to marker a new music recording that is expected to have target sales of $20 million for upcoming year
The marketing department has estimated that 1% increase in advertising will translate to 0.5% increase in sales
And 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?
Scenario
Question

10. Advertising 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 demand
Price elasticity of demand

11. Highest Ad-to-Sales Ratios

12. Lowest Ad-to-Sales Ratios

13. Example: Credit Card Industry

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

15. Example: Airline Industry

16. Ad to Sales Ratios

17. Ad to Sales Ratios High or low? Transportation/Travel industry =1.9
Consumer Products, Books, PayTv, Communications, all > 5
Downward Trend

18. Market Concentration Numbers and size distributions of firms
Different Market Structures
Numbers and size distributions of firms
Ready-to-eat breakfast cereals: high concentration
Newspapers: low concentration
Measurements of market structures
Concentration ratio,
Herfindahl-Hirschman Index (HHI)
Lerner Index (LI)

19. Industry Concentration
Four-Firm Concentration Ratio
The sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST 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 wi2, where wi = Si/ST.

20. Measure of concentration
Firm Rank
Market Share
(%)
Squared Market Share
625
625
625 25 25 25 25 25
Concentration Index

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

22. Measure of concentration
Firm Rank
Market Share
(%)
Squared Market Share 1 25
625 2 3 4 5 6 7 8 Σ 10 Σ
100
Assume firms 4 and 5 merge
Concentration Index

23. Measure of concentration
Firm Rank
Market Share
(%)
Squared Market Share 1 25
625 2 3 4 5 6 7 8 Σ 10 Σ
100
The concentration indices change
Concentration Index
CR4 = 80 85
H = 2,000
2050

24. 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
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
Example
E.g. The cigarette industry is highly concentrated with only 8 firms and a Herfindahl-Hirschman Index (HH1) of 2623

25. Example: Candy and Chocolate Industry

26. Candy v. Chocolate CANDY HHI (for top 4) = 1141 CR ₄ = 59%
Medium level concentration
->Concentration is increasing!
1,039 businesses overall!!
CHOCOLATE
HHI (for top 4)=
Cr ₄ = 78.1%
High level of concentration
518 Businesses overall!!

27. CR₄ and HHI: Candy Industry
The HHI for just the top 4 companies in the industry is
The CR ₄ for the industry is 78.1%.
Therefore, the industry is highly concentrated with only a few major firms holding a majority of the market share.
CR ₄ = = 78.1%
*Hershey and Mars Inc. alone hold 71.1% of the market share.
-Note that students calculated HHI incorrectly (need to add squared market shares for top 50 companies, not only top 4)

28. Example: Credit Card Industry

29. Market Definition 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:
Total Number of Companies: 192

30. 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
Patterns

31. Worldwide Ad Spending by Region (2013)

32. Advertising by Media in the US

34. TOP 10 Brands in 2012

35. Product Differentiation
Definition
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.
Variation
Product Brand
Packaging
Condition of Sale
Service Provided
Location
Strategy
Product Differentiation as an Entry Strategy
Product differentiation to create a niche market.
Product differentiation to deter entry.

38. Ad Elasticity and Concentration1
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. 2 3

39. 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.

40. Perceptual Maps

41. Perceptual Map: Credit Cards

42. Perceptual Map: Credit Cards
Uniformity
American
Express
Accessibility
Chase
Selectivity
B of A
Citi
Variety

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

45. On the other hand…
Advertising 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.

46. Taxonomy of Products and Their Attributes

47. 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 Attributes
Credence 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.

48. Taxonomy of Goods-Nelson (1974), Lieberman and Flint-Goor (1996)
Search Goods
Non-Durable Exp. Goods
Durable Exp. Goods
Experience Services
Credence Services
Clothing
Furniture
Footwear
Carpets
Mattresses
Health/Beauty
Cigarettes
Food
Cleaners
Newspapers
Office Supplies
Housing
Autos
Hardware
Drugs
Glass
Software
Signs
Books
Sporting Goods
Hobbies
Utilities
Advertising
Transportation
Vacations
Education
Training
Tours
Banking
Car Rentals
Entertainment
Direct Mail
Real Estate
Cargo
Job Placement
Information
Nursing Homes
Sports Clubs
Hotels
Waste Collection
Landscaping
Investments
Trusts
Portfolio Management
Mutual Funds
Insurance
Health Care
Weight Control
Car Repairs

49. 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.

50. Product Attributes Most Goods Most Services High in search
Easy
Difficult
to evaluate
to evaluate
Clothing
Chair
Motor vehicle
Foods
Restaurant meals
Lawn fertilizer
Haircut
Entertainment
Computer repair
Education
Legal services
Complex surgery
High in search
High in experience
High in credence
attributes
attributes
attributes

51. 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

52. 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.

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

54. Life Cycle of Product

55. Persuasive Advertising

56. 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.

57. 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?

58. The Pervasiveness of Persuasion
The average person is exposed to 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)

59. Obvious Forms of Persuasion
A 30 second spot for Super Bowl costs $3-4 million for a 30 second spot.
Product placements in movies and TV amounted to $2.5 billion in 2005 (PQ Media).
Morgan (2005) “between products are inserted in every half hour of television programming”.
Product Placement on American Idol

60. Product Placement http://www.brandchannel.com/brandcameo_film s.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 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 Radio

61. 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, vi, 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  * vi.

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

63. 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.

64. 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.
More about that later, when we talk about complementary view.

65. PBS Frontline: PERSUADERS/

66. Complementary Advertising

67. 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

68. 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.

69. Complementary View Associated with the Chicago School
Definition
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
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.

70. Mission 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.”

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

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

73. 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.

74. 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?

75. Is True Luxury Dead? Not all
E.g. Hermes Kelly and Birkin bags are painstakingly made in workshops in France;
Classic perfume Chanel No.5 is still created using the finest ingredients in a small scale operation.

76. Example: Credit Card Industry

77. 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