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

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

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

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

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).

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

Lowest Ad-to-Sales Ratios

Example: Credit Card Industry

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

Example: Airline Industry

Ad to Sales Ratios

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

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)

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.

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

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

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

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

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

Example: Candy and Chocolate Industry

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)= 2941.81 Cr ₄ = 78.1% High level of concentration 518 Businesses overall!!

CR₄ and HHI: Candy Industry The HHI for just the top 4 companies in the industry is 2941.81. 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 = 49.5 + 21.6 + 4 + 3= 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)

Example: Credit Card Industry

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: 1810-1850 Total Number of Companies: 192

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

Worldwide Ad Spending by Region (2013)

Advertising by Media in the US

TOP 10 Brands in 2012

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.

Ad Elasticity and Concentration 1 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

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

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

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

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.

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 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.

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

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 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

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

Persuasive Advertising

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 $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 15-30 products are inserted in every half hour of television programming”. Product Placement on American Idol

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

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.

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

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

PBS Frontline: PERSUADERS http://www.pbs.org/wgbh/pages/frontline/shows/persuaders /

Complementary Advertising

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 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.

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.”

Price Premium Pricing Never on sale!! Price range: 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?

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.

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