AEM 4550: Economics of Advertising Prof. Jura Liaukonyte LECTURE 3: ADVERTISING ELASTICIES

Plan of the Lecture  Other Elasticities  Advertising Elasticity  Measures of Market Concentration  Relationship between Advertising and Market structure:  Dorfman-Steiner Condition  Optimal Advertising levels  Advertising to sales ratios across different industries  Product differentiation and Advertising

Super Bowl Ads  The 21 most-watched television programs in American history are all Super Bowls  Super Bowl 2015 delivered its highest overnight TV rating ever  111.5MM viewers in 2014  114.5MM viewers in 2015  Cost of exposure in 2015, $4.5 million for a 30-second spot  Average CPM on TV for 2015 = $  CPM – Cost per Mille - price an advertiser pays to reach a thousand viewers  Calculate CPM for a 2015 Superbowl ad = 4.5*1000/114.5 = $39.3

Price Elasticity of Supply  Measures the sensitivity of quantity supplied given a change in price  Measures the percentage change in quantity supplied resulting from a 1 percent change in price

Income Elasticity of Demand  Measures how much quantity demanded changes with a change in income DefinitionFormula   Sign indicates normal or inferior  E I  >0 implies normal good. E I  <0 implies inferior good.   Normal goods may be necessity or luxury.

Cross Price Elasticity  Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good DefinitionFormula   Complements: Cars and Tires   Cross-price elasticity of demand is negative   Price of cars increases, quantity demanded of tires decreases   Substitutes: Butter and Margarine   Cross-price elasticity of demand is positive   Price of butter increases, quantity of margarine demanded increases

Size of shift in Demand E XY >1 E XY <1 Demand for Product Price D D’ D D’ Assume P subst Increases Price

Example: The Cross-Price Elasticity of Demand for Cars  Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995),

Advertising Elasticity  Measures the sensitivity of demand given a change in advertising

Advertising Elasticity  Ad-inelastic demand curve: Demand does not shift much from advertising.  Example:  concrete: Consumers’ purchasing decisions are mostly based on price and related terms of sale.  Ad-elastic demand curve: Demand is relatively responsive to advertising.  Example:  soda: Consumers’ purchasing decisions can be easily swayed by effective advertising campaigns.

Advertising Elasticity  Two key results from advertising  The marginal gain from advertising expenditures is greater the more sensitive the demand curve is to advertising expenditures.  Firms should advertise more when the demand curve is more sensitive to advertising expenditures.

 Lerner Index: L = (p - MC)/p = 1/|E P |  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. Lerner Index

What are Sources of Monopoly Power? Low elasticity of demand We just showed this using Lerner Index. Possibly due to strong product differentiation. High barriers to entry e.g., ownership of necessary raw materials, patents and regulatory barriers, scale economies, product diff. Number of other competitors in market. Interactions between firms: Compete or cooperate?

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.

Product Differentiation, cont.  Ways in which products are differentiated.  Product Brand  Packaging  Conditions 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 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  Recall, 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.

Dorfman-Steiner  The Dorfman-Steiner formula relates the sales 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).

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.

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

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

Highest Ad-to-Sales Ratios (2010 data)

Lowest Ad-to-Sales Ratios

Profit Maximization: MR=MC Optimization Set Up profit(q) = TR(q) – TC(q) profit(q) = TR(q) – TC(q) How to maximize profit? How to maximize profit?

Profit Maximization: MR=MC Optimization Set Up profit(q) = TR(q) – TC(q) Profit maximization: dprofit/dq = 0 This implies dTR(q)/dq - dTC(q)/dq = 0 But dTR(q)/dq = marginal revenue dTC(q)/dq = marginal cost So profit maximization implies MR = MC

Profit Maximization: Monopoly Condition Derivation of the monopolist’s marginal revenue $/unit Quantity Demand MR A With linear demand the marginal revenue curve is also linear with the same price intercept … but twice the slope 1. Demand: P = A – B*Q 2. Total Revenue: TR = P*Q = A*Q – B*Q 2 3. Marginal Revenue: MR = dTR/dQ 4. MR= A-2B*Q

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

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 Concentration Index Firm Rank Market Share (%) Squared Market Share

Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ Measure of concentration

Measure of concentration Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ CR 4 = 80 H = 2,000

Measure of concentration Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ Assume firms 4 and 5 merge

Measure of concentration Concentration Index Firm Rank Market Share (%) Squared Market Share Σ Σ CR 4 = 80 H = 2,000 The concentration indices change

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

Example: Candy and Chocolate Industry

Example: Credit Card Industry

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 Market Definition

What is a Market? No clear consensus the market for automobiles should we include light trucks; pick-ups SUVs? the market for soft drinks what are the competitors for Coca Cola and Pepsi? With whom do McDonalds and Burger King compete? Presumably define a market by closeness in substitutability of the commodities involved how close is close? how homogeneous do commodities have to be?

Fast-Food Outlets Burger King McDonald’sWendy’s