Managerial Economics/Economics of advertising

Limited Information: Effects on the Market edit

Products or services can be grouped into 3 separate categories, each with a varied amount of information/utility provided before and after consumption.

  • Search Goods
  • Experience Goods
  • Credence Goods

Search goods: A search good is a type of product which the buyer can determine/ have access to all facets of the quality of the product at the time of purchase. For example, a consumer could determine all the important attributes of a diamond at the time of purchase, whereas wearing a gifted diamond does not generate any additional information. Search goods are typically contrasted with an experience good or credence good that is difficult to judge in terms of quality, functions, features or price before a purchase.

In order to differentiate products in the market, this predominantly relies on enhancing observable features. Hence, when a firm is selling a search good that possesses certain qualities, the seller wants the customer to see these attributes first hand by providing an opportunity for the consumer to fully observe the good. In this case the seller’s reputation is not so much in question, as the attributes of the good is what speaks for itself.

These are the examples of search goods.

  • Electronics: Electronics such as tablets, computers and phones. Nowadays, it is common for electronics to be filled with reviews, opinions and information about the functions, feature, quality and usability of these popular devices.
  • Restaurants: Restaurants used to be considered an experience good. However, nowadays, reputation systems has made it possible to research restaurants in advance of a visit, allowing users to review the restaurant experiences.
  • Movies: The reviews and trailers allow the quality of a film to be estimated in advance.

Experience goods: An experience good is a product or service that is difficult to evaluate in advance in areas such as price and quality, as this can only be assessed after the product has been consumed. For example, a buyer may not be able to decide if he/she likes the taste of a type of soft drink, until the beverage has been consumed. In some cases, products have to be used for a duration of time to determine how satisfying it is. For example, a consumer may not be able to evaluate the quality of a skin serum until they see the results over a duration of several weeks.

When selling an experience good, sellers must strongly indicate the value of the product to ensure that the buyer is satisfied post-purchase. Since the buyer does not get appreciate the good until after the it has been consumed, the buyer purchases under uncertainty. Therefore the selling firm’s reputation for delivering products that perform as promised is a crucial element of the purchase process. In addition, customer loyalty and word of mouth is extremely valuable as these are the primary things that customers can use to make purchasing decisions. Therefore, the indirect information contained in advertising is especially important for experience goods.

These are the examples of experience goods:

  • A Haircut. It is difficult to tell how a haircut will turn out until it's done. A customer who is satisfied is likely to return.
  • Travel. travel experiences such as an day tour or day trip are often difficult to evaluate upfront.
  • Medicine. A patient may have little knowledge about the talent, equipment and process differences from one hospital to the next. In a country where medical treatment isn't free for local residents, the price may also be a mystery.

Credence goods: A credence good is a product or service that is difficult for the customer to value, even after it has been consumed. Credence goods are usually some kind of expert service where the customer is unable to fully understand the value of the good or service that they are paying for. Credence goods often have information asymmetry where the two parties have different levels and understandings of the good's relevant details. Information asymmetry can lead to exploitation of the party with lesser information. Customers may think that a credence good is high quality when it is actually low quality. Additionally, customers may also be dissatisfied with high quality credence goods because it is difficult for them to see its value.

Two possibilities of credence goods:

1. Consumers do not know if they need the good or service but they can satisfy your needs and notice the utility it provides.

2. Consumers know what they want or need, but cannot observe the utility derived from their consumption.

These are examples of credence goods:

  • Education. It is difficult to know the quality of the education.
  • Medical services. It is difficult for patients to evaluate the quality of medical services and treatments.
  • Consulting. Consulting such as legal advice given by experts is difficult for a client to evaluate.

The selling processes associated with these types of goods ensure that consumers purchase goods that match their ideal needs. These types of goods reduce the risks of buying under uncertainty as the attributes of search goods are revealed at the time of purchase, and reputation and credibility are reference points used to guide consumers in their purchases of experience goods.

Indirect effects of advertising

1)Ambiguous relationship between advertising and market concentration

Since bigger firms are able to afford larger advertising expenditure, advertising has an impact on market concentration. Due to an economies of scale in advertising, larger firms will be able to enjoy lower cost in producing advertisement thus it will lead to a more competitive market with high concentration ratio, and promote the market to move towards oligopolistic structure. However, there is also research showing that high promotion may be associated with less concentration, like for brewers. Bagwell (2007) "economists emphasized that the causality between advertising and concentration might run both ways, with concentration also influencing advertising" (p. 1736). Therefore, a more complex and ambiguous relationship exist between advertising and market concentration, and the accurate interpretation is unable to determine yet.[1]

Costly search edit

Imagine a person is looking for an apartment, how many inspections will he make before final decision?

  • Assume the person is searching from a payoff distribution from $0 to $9, which is [$0, $8] evenly and the person is risk neutral.
  • An offer (inspection) will be obtained from the distribution each period, the person will have to decide to accept (take the apartment) and get the payoff or reject and get another offer.
  • - Every new offer cost $0.5 (Search cost).

Assume there are 5 offers existing and payoffs are given in the diagram (1):

Offers Satisfaction Payoff
Offer 1 $3 $2.5
Offer 2 $1.5 $0.5
Offer 3 $2.5 $1
Offer 4 $2 $0
Offer 5 $8 $5.5

Optimal reservation amount of a risk neutral person: According to (1), the highest payoff is $5.5 (Offer 5). Assume current draw is Offer 1 ($3.50), therefore the chance to get a better offer (Offer 5) will be ¼. As a result, on expectation the person will have a 25% chance of getting an $3 improve on current offer, which give the person an expected payoff (E) of $3 * ¼ = $0.75. Hence, the person might call a for new offer for E>$0.5.

  • If E=$0.5, the person will be indifference between accepting of rejecting.
  • If E<$0.5, the person will absolutely keep his offer.

Optimal reservation amount of a risk averse person: Assume the person holding Offer 1 will be unhappy if the new payoff is lower than current payoff and causing a $0.25 deduction on expected payoff. The expected payoff of getting a worse offer will be:

E1= (-$2) * ¼ + (-$1.5) * ¼ + (-$2.5) * ¼ - $0.25 = -$1.75

The expected payoff of getting a better offer will be:

E2= $3 * ¼ = $0.75

The aggregate expected payoff E will be:

E = $0.75 + (-$1.75) = -$1

Because -$1<$0.5, so the person will accept the offer.

Tourist trap model Imagine Cena, a tourist wants to buy a boomerang in Brisbane, but Cena cannot shop around to find the lowest price because he is going back soon. Cena has a guidebook which reports the price range of a boomerang, but without exact price in a specific shop. The cost of travel from one shop to another is C and price of a boomerang is P, so:

  • - Cost of purchase in the first shop will be P + C
  • - Cost of purchase in the second shop will be P + 2C

In this case, what will be the price strategy for each shop if there are many shops in the market?

Assume everyone in the market will charge P1. To exploit the search cost, one shop, let’s say shop A will probably charge P1 + σ, where σ < C. If Cena walks into shop A, even if he knows the price is above market price, he will purchase for the cost for going to other shops will be P1 + C > P1 + σ.

In conclusion, in markets where consumers have information about price distribution, monopoly price will be an equilibrium than competitive price even there are many sellers selling homogeneous goods.

Information search in the internet markets: Experience versus search goods edit

Search goods have a great number of attributes that can provide full information to consumers prior to purchase. Basu, Shreya (July 2018). "Information search in the internet markets: Experience versus search goods". Electronic Commerce Research and Applications 30: 25-37. Retrieved 2019-10-12.  This is because consumers have the opportunity to inspect a search good before purchasing it. Experience goods have an array of attributes that do not provide full information to the consumer before being used Basu, Shreya (July 2018). "Information search in the internet markets: Experience versus search goods". Electronic Commerce Research and Applications 30: 25-37. Retrieved 2019-10-12.  This is because experience goods must be purchased and subsequently used before it is possible to evaluate the quality of the good.

This means that information search for experience goods tends to be more expensive when compared to search goods. Search goods can provide full information to consumers through methods such as user reviews, advertising, word-of-mouth, etc. all of which are generally cheaper methods of attaining full information of a product when compared to purchasing an experience good to gain full information Basu, Shreya (July 2018). "Information search in the internet markets: Experience versus search goods". Electronic Commerce Research and Applications 30: 25-37. Retrieved 2019-10-12.  In addition to this, buyers tend to adhere to the recommendations of others for experience goods then for search goods . Nelson, Phillip (1970). "Information and consumer behavior". Journal of Political Economy 78 (2): 311-329. Retrieved 2019-10-12.  It is noted that the recent rise to prominence of electronic commerce and the boom in online shopping popularity now exposes consumers to a greater range of information when compared to more traditional brick and mortar stores Klein, Lisa (March 1998). "Evaluating the Potential of Interactive Media through a New Lens: Search versus Experience Goods". Journal of Business Research 41 (3): 195-203. Retrieved 2019-10-12.  This may more than bridge the gap between experience and search goods. A recent study concluded that search good search intensities are at least three times higher than experience goods. The same paper also concluded that online recommendation agents have a significant impact on search goods when compared to experience goods Basu, Shreya (July 2018). "Information search in the internet markets: Experience versus search goods". Electronic Commerce Research and Applications 30: 25-37. Retrieved 2019-10-12. 

Asymmetric information edit

Asymmetric information is when one of the parties in a transaction (typically the seller, although not always) has access to more of the relevant information than the other, giving them an advantage in negotiations. This brings forth issues of 'the market for lemons,' which describes the market for second-hand cars.

The impact of 'lemons' is a great example of how asymmetric information affects the used-car market. 'lemons' describes pre-owned vehicles in poor condition. The sellers are aware of pre-existing faults with the vehicle or 'lemon' they are selling, while the buyer is not. The price of the average car is determined by the willingness to pay for the average quality of car. However, at the price some buyers worried about the risk of purchasing a 'lemon' may want a price reduction, while sellers of cars in better condition than the average car on the market, may not be willing to sell at that price. The result is that disgruntled sellers of healthy cars may take their vehicle off the market. Only sellers of low quality vehicles are willing to sell at that given price. This problem reduces the average quality of car on the market and causing a further reduction in price, compounding the problem. This eventuates to a greater density of 'lemons' being offered which promotes, the possibility of a market breakdown.

Problems due to Asymmetric information edit

  • Adverse selection - When one party of a transaction possesses information known by him or herself and is kept hidden from the other party in the transaction, which is used to gain an economic advantage by the former. This can lead to potential losses in total welfare as consumers may avoid dealings with better-informed sellers.
    • Using the previous example of market for second-hand cars, sellers are able to keep information such as engine problem not noticeable by people without mechanical knowledge. The buyer without information or knowledge of the condition would buy it giving an economic advantage to the seller. Conversely, a seller who has bought a brand new car, with no hidden faults, who decides to sell it for some other innocent reason, may not be able to recoup anything close to the amount he paid the dealership, despite the cars condition not changing. This is because savvy buyers will assume that the car is being sold because there is something wrong with it, and will do business accordingly.
  • Moral hazard - When one party is informed and engages in risky transactions or activities that is unobservable by the other party and implicates the latter.
    • A common example for moral hazard is the insurance example. Buyer of an insurance will be more keen to engage in risky activities as compared to before buying an insurance, such as skydiving as he/she knows that any injuries will be covered by the insurance.

Why do Consumers Respond to Advertising? edit

Advertising edit

Advertising is an effective market tool used to promote and sell products or services. It involves directly communicating through persuasive message about a business, product or service to influence a consumer's behaviour towards purchasing a product or service. Successful advertising campaigns shift the market demand curve to the right by influencing consumer preferences or it can introduce consumers to new products.

Informative advertising

Informative Advertising is a method of promotion that is used to inform customers about the benefits, prices, and features of products. Informative advertising is used to increase consumer awareness of the company and increase exposure of other products that might build the brand image. As an example, medicine advertisements list the side effects of using the medicine in a non-persuasive manner, although the remainder of the ad is designed to persuade. Informative advertising describes the product's existence, characteristics and terms of sale (E.g. The Shamwow). In this approach to advertising, many markets are characterized by imperfect consumer information as consumers may be deterred by search costs after finding out the product's existence, price, and quality.

For example, Amazon will use informative advertising to inform the people, the big sale of Black Friday will start in November. Another example would be an informative advertisement for a new automobile that may stress safety features, a power train warranty and gas mileage as the primary product assets in an attempt to attract consumers.

Informative Advertising Model

The informative advertising model is based on the premise that consumers are more inclined to be knowledgeable on a product they are interested in before they spend money buying it. From this observation, firms can attract customers and increase sales by educating their customers about their offered products through advertising. Advertisements that deliver product information to the target market is considered informative advertising, as opposed to persuasive advertising which does not necessarily give customers a deeper understanding of the product. The information can be about the existence and/or usefulness of the product, the price, the specifications, etc.

The model assumes a total of N identical consumers in the market, who are willing to buy a quantity of q(P) of the product (quantity demanded is still dependent on the price P of the product) if they are sufficiently informed about the product. A firm can spend s amount of expense to advertise their product; the more they spend on advertising, the more people will be informed. Through this relationship, demand – and therefore, profit – will increase as s increases. However, increasing s means increasing costs for the firm. Therefore, the firm will maximise profit by optimising their advertising costs such that the marginal revenue gained from s is equivalent to the marginal cost of s.

Persuasive Advertising

Persuasive advertising is a method of promotion that is used to persuade the audience (consumers) to purchase the advertised products or services. This method is usually used to attract new consumers, encourage customers to try new products and change the current attribute of the brand or products. It can also be used to encourage current customers to buy newer versions (updated) of the products continually which might increase customer loyalty. Through persuasive advertising, the company can emphasize the features and benefits of its own products to attack competitors; hence, it can "steal" new customers from competitors. Persuasive advertising is designed to shift consumers' preferences by altering consumer taste (E.g. Lamb ads with Sam Kekkovich). In this view, advertising is seen to alter customers' tastes and create product differentiation and brand loyalty. This results in the demand for the product becoming more inelastic and therefore an increase in price. Thus, this persuasive approach suggests that there are important anti-competitive effects in advertising as it does not bring to customers any “real” value. Rather, it induces product differentiation which results in concentrated markets having higher prices and profits. (Bagwell 2007)[2]

The Crowd Appeal Model: Attempts at persuading consumers to purchase a product or pay for a service by making them feel that a product or service is mainstream and that the general consensus of consumers are also buying the product.

  1. Total of N consumers in the market
  2. Each consumer will buy only one unit of the primary good.
  3. Each consumer has a different value, Vi, for the primary good.
  4. Advertising increases each consumer's value by the same factor,𝜎, regardless of their initial value. Thus each consumer's value with advertising is 𝜎×Vi
  5. Increase in consumers' willingness to pay,𝜎, is a function of the amount spent on advertising.
  6. As s increases,𝜎(s) increases, as does consumer demand and profit.
  7. Firms will select the level of advertising that maximises profit, for example, the level of s where the marginal revenue from s is equal to the marginal cost of s.

In this model, higher levels of advertising lead to higher prices because advertising increases the consumers' willingness to pay. A consumer's willingness to pay (WTP) is maximum price a consumer will with certainty buy a product or pay for a service. As advertising increases increasing WTP, the demand curve flattens thus increasing the equilibrium price elasticity of demand and lowering equilibrium price, making advertising profitable as it raises the level of demand.

Also, advertising can increase consumer surplus as well as firm profit, since advertising increases a consumer's value.

Influential Advertising Mediums edit

Approximately 90% of consumers’ purchases are influenced by advertisements. Advertisements are often large investments, including factors such as target markets, timing, projected annual gross profits etc. However, many advertisements are overlooked and ignored by buyers because the advertisements are often perceived as non-authentic and trustworthy.

In order to ensure that advertisements reach the target market, the advertisements require the appropriate reach, engagement, and conversions, while all maintaining within budget. There are seven main influential advertising medium, incorporating information advertising and persuasive advertising, which are considered trustworthy and are more likely able to reach more consumers.

1. Mobile

A majority of consumers nowadays have access to a mobile device, allowing them to check prices online or browse for product information before making a purchase. The Internet Advertising Bureau (IAB) in 2016, stated that more than 50% of internet advertisement revenue comes from mobile adverts. This suggests a shift towards ‘mobile-only’ marketing, rather than ‘mobile-first’ marketing, to keep up to date with today’s highly mobile consumers. Several mobile ads include banners, interstitials, videos, and native ads. These ads popup in within apps run on the phone, allowing advertisers to specifically target their preferred audience, and the software companies creating the apps to discriminate on the price of advertising.

2. TV

Although many consumers are switching to mobile and social platforms, reports show that the average individual still watches approximately five hours of TV a day. This medium is still the most influential and trustworthy medium today, contributing approximately 60% towards purchases, compared to print (45%), online (43%), and social media (42%). This is because TV stimulates both the auditory and visual systems of the individual which improves attention, retention, and impact.

3. Video

Over 70% of marketers are planning to increase their usage of video advertising. Videos are easy to consume and can be highly informative, allowing for presenting the product in a genuine and memorable way. Videos also allow for targeted message delivery, and video virality activates audience engagement. A successful viral video marketing campaign has at its core a video which is sufficiently compelling that its audience members share it to friends and family, creating a viral cascade of people sharing and talking about the video across the internet. This allows the customers to actually seek each other out instead of the marketer having to do it.

4. Email

Emails allow for segmenting, targeting, and triggering ads. Personalised emails allow consumers to distinguish brands and become more memorable. A successful email campaign results in increased site traffic, improves engagement, increases customer retention, and accelerates upselling and cross-selling. The first step is to create seductive and attractive headlines to fight through the mass and noise of emails consumers receive each day. An unsuccessful email campaign on the other hand is unable to distinguish itself from other advertising in customers' email inbox. This has become the primary issue in any email campaign, with the market already being flooded with competitors for the attention of potential customers.

5. Search Engine Marketing (SEM)

Search Engine Marketing, such as Google Ads, are similar to physical billboards but are much larger. SEM is able to reach approximately 80% of global internet users. SEM allows for bidding on advertising keywords through an auctioning process. Your advertisement is then placed above the top-ranked search result for those keywords. Once a viewer or consumer clicks the ad, you will pay the respective cost. Effective applications include B2B awareness, niche keywords, product listings, retargeting, and campaign-related support.

6. Retargeting

A powerful tool to secure conversions. Once a viewer or consumer accepts your website cookies, you are able to track them via a targeting pixel. This allows you to provide personalised ads on and across various retargeting platforms such as Facebook or Google. This helps to find the right consumer at the right moment.

7. Podcasts

Podcasts provide a blend of influencer marketing, trustworthiness and on-demand radio and podcasts to become as effective ad medium. Typical podcast listeners are educated, urban, and affluent. Listeners feel as if they know the hosts personally over time and as such take recommendations from them far more to heart than other advertising. They become engaged and loyal over time; often participating in discussion surrounding the podcast, and building trust in the hosts. 65% of consumers increase purchase intents, 45% are more likely to visit the advertiser’s website, 42% would consider the new product, and 37% engage in research after listening to a podcast advertisement.

Advertising Price edit

Advertising intensifies price competition by transforming the tourist trap model to the Bertrand Model. In general, it can be said that advertising increases price competition.

  • This is because the shift from uniform advertising to targeted advertising can transform a purely vertically differentiated market into a mixed market, which certain features of monopoly and thus changes the price competition pattern among enterprises.

Advertising as a complementary good edit

Advertising can add value to a good. It can complement the primary good because consumers value the consumption of the good as well as the ad itself. A company can get a higher demand for their product by advertising it. Here, it is assumed that customers have a strong set of preferences in which advertising enters directly in a manner that is complementary to the consumption of the advertised product. For example, the Super Bowl commercials add value to the products because they are very well received by consumers. Standard methods are one important implication that may be utilized to analyze whether advertising is assigned to a socially optimal level, even though advertising does not bring in any information. (Bagwell 2007) [3]

Advertising as a Signal of Quality edit

For experience goods advertising is often used to signal the quality of the product. If a company engages in an expensive advertising campaign, consumers may infer that the good is of high quality even if the advertisement contains little apparent information about the product being advertised because only high quality and large firms could undertake an expensive advertising campaign (E.g. Swiss Multivitamins).[4] The willingness of the firm to spend a large amount of money on advertising can itself be a signal to consumers about the quality of the product being offered. Consider a firm introducing a new energy drink. A typical advertisement might have some highly paid actor using the drink before a workout and claiming how wonderful it tastes. This type of advertising does not need to be informative as it is motivated by signaling. What the advertisements say is not as important as the fact that consumers know that ads are expensive. [4]

Search Costs edit

One reason for why the willingness to search for the right product varies between consumers is due to the difference in search costs. Search costs can be represented by physical inspection, monetary costs and time consumption. As the number of searches increases, the total cost of searching for the right product increases. Search costs may prevent consumers from gaining extra information about the product, such as its existence, price and quality. Consumers have heterogeneous search costs for a number of reasons. Rational consumers will continue to search for better products or services until the marginal cost search cost exceeds the marginal benefits.

As each consumer's marginal benefit and marginal cost schedules are different, some consumers are willing to incur high search costs (MC) in order to attain relatively small information gains (MB). On the other hand, some consumers do not value additional product information highly and are not willing to incur high search costs to become knowledgeable about the product. Another reason for heterogeneous search costs is consumers have different reference points, based on their individual reservation prices. The reservation price is the maximum price that a consumer is willing to pay for a product/service. If we include search costs in the price of a product, it is clear that as consumers' budgets vary and as a result their reservation prices vary, the maximum amount a consumer is willing to pay will depend on the value of their reservation price and the associated search costs.

Search Theory edit

In the real world, market participants face a problem of imperfect and costly information which influences their decision making. Search theory is a study that explains how market participants decide when to accept an offer for a transaction.

Example: Search for a higher wage

  • Assumptions:
    • Uniform wage distribution between 100€ and 200€ (wage payment is equally likely to take any value between 100 and 200).
    • The cost of a new search is 5€.
    • Suppose the 1st offer is 150€.
  • The question we ask ourselves is whether we should pay 5€ for a new search.
    • Suppose next offer will exceed 150€, the expected value we can expect will be between 150€ and 200€ with average of 175€ ((200+150)/2=175). As a result, the potential gain over and above 150€ is 25€.
    • The probability of getting a wage offer at least as large as 150€ is 0.5 ((200-150)/(200-100)).
    • Putting the above together, the expected gain EG(150) = (0.5)(25) = 12.50€ which is greater than the cost of search.

Concluding, a person should pay for a new search as long as the expected gain is larger than the cost of search. The optimal reservation offer is the one for which the expected gain is equal to the cost of a new search.

Tourist Trap Model edit

The Tourist Trap Model assumes the following:

  • All shops have the same costs and sell homogeneous goods
  • All consumers have identical demand functions
  • A guidebook provides each consumer with a general distribution of prices charged, but does not give the specific price each shop charges.

The tourist trap model describes the cost incurred as a tourist due to the limited information they have when buying a good/product. This can lead to overpriced goods and exploiting tourists due to price uncertainty and limited budget to cover search cost (e.g. time).

It costs a tourist C in time and expenses to visit a shop to check the price or buy a specific souvenir. If the price of the souvenir is p, then the total cost of buying the souvenir at the first shop is: p + c If the tourist visits two shops before buying the souvenir at the second shop, the cost of the souvenir is: p + 2c Therefore the tourist wants to find the lowest price for the souvenir while also minimising how many shops they visit.

The tourist trap model states that it costs each tourist time 'c' and expenses to visit a shop to check the price or buy a good/product. Hence, if the price of the good/product is P, the cost of buying that good at the first shop that the tourist visit is P + c. If the tourist visits two souvenir shops before buying at the second shop, the cost of the good is P + 2c.

P + c is the lowest price the tourist could pay since they need to visit at least one shop. If the tourist visits two shops, their search costs are 2c.

Assume that P* as price all other souvenir shops charge. A firm thus can profitably charge P1 = P* + e, where e = a small positive number representing the individual shop's markup price.

If consumers (in this case tourists) have limited information about the price of a good, an equilibrium in which all firms charge the full-information, competitive price is impossible.

Fixed Number of Firms edit

Assume there are initially a fixed number of 'n' stands. What would the price of a product be? Firstly consider whether each shop charges the price 'pc' which is the full-information, competitive price that also equals the constant marginal cost Carlton, Dennis W (2015). Modern industrial organization Dennis W. Carlton, Jeffrey M. Perloff.. pp. 477-480. Retrieved 2019-10-12. 

Breaking the Full-Information, Competitive Equilibrium edit

It must be determined whether any firm has an incentive to deviate away from the full-information, competitive equilibrium (marginal cost = price) in order to determine in that price holds when consumers have limited information. Firms break the equilibrium when they deviate from this proposed equilibrium. This of course means that the proposed equilibrium is not an equilibrium at all.

It pays for a deviant firm to charge a higher price when all other shops set their price to the full-information, competitive price 'pc'.A deviant firm will not lose its customers when it charges p* = pc + e, where e is a small, positive number, and still be profitable Carlton, Dennis W (2015). Modern industrial organization Dennis W. Carlton, Jeffrey M. Perloff.. pp. 477-480. Retrieved 2019-10-12. 

Reducing Search Costs edit

It has been found that so long as the search costs are positive and there is a single-price equilibrium, the equilibrium price will not change. Consumers have full information when search costs fall to zero, at which point the only equilibrium possible is at price equals 'pc', which also equals to marginal cost Carlton, Dennis W (2015). Modern industrial organization Dennis W. Carlton, Jeffrey M. Perloff.. pp. 477-480. Retrieved 2019-10-12. 

Nonexistence of the Single-Price Equilibrium edit

The proposed single-price equilibrium at which all shops set price equal to the monopolistic price 'pm', and where search costs are positive, the proposed equilibrium may be broken depending on the number of firms, the search costs, and the shape of the consumer demand curve Carlton, Dennis W (2015). Modern industrial organization Dennis W. Carlton, Jeffrey M. Perloff.. pp. 477-480. Retrieved 2019-10-12. 

Persuasive Advertising: Crowd Appeal Model edit

The Persuasive Advertising Model assumes that:

  • There is a 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.

Through advertising, each consumer's value of the primary good is increased by the same factor 𝜎, regardless of their initial value. Hence, the consumer's value resulting from advertising can be expressed as 𝜎 x Vi. The advertising increases the consumers' willingness to pay, 𝜎, which is a function of the amount spent on advertising s. In other words, consumers' willingness to pay is directly related to the amount spent on advertising. As spending on advertising increases, so does the consumer's willingness to pay, which in turn increases consumer demand for the product and profit for the firm. Firms will select the level of advertising that maximises profit, i.e. the level of s where the marginal revenue from s is equal to the marginal cost of s. In this model, higher levels of advertising lead to higher prices because the advertising increases the consumers' willingness. Furthermore, advertising also increases consumer surplus since advertising increases the consumer's value as well as increasing the firm's profit. Summed up, the higher advertising leads to higher demand for each consumer, which leads to higher prices.

Informative Advertising Model edit

The Informative Advertising Model assumes that:

  • There is a total of N identical consumers in the market.
  • Each consumer will buy q(P) of a product if informed about it.
  • The number of consumers informed depends on the amount spend on advertising (s).

Information advertising is a technique use to educate the public on the characteristics and products existence. The following factors are included in information advertising:

  1. The key features and benefits of the product or service
  2. What the product of service can do or is capable of doing
  3. Compared to other substitute products/services in the market by comparing the values and benefits of the product or service
  4. The location of the product or service and where it can be purchased/consumed

Crowd Appeal Model vs Information Advertising Model edit

  • Advertising as Crowd Appeal - increased levels of advertising leads to increased demand for each customer, which leads to higher prices
  • Advertising as Information - increased levels of advertising will lead to an increase in the number of customers but not an increase in the demand for each customer. Because of this prices are not effected by advertising levels

Monopoly Advertising edit

Monopoly advertising is all about the monopolist having the full autonomy to choose a mode of advertisement that serves their own self-interest.

One model that helps to explain such a concept is the Dorfman – Steiner model.

An example to explain the model is the following:

  • Suppose that a monopolist sets a price, P, of its product, and A, which is the amount of advertising. K is “the cost per advertisement” and “is assumed constant”.
  • Market demand can thought of as the function of D (P, A) where restrictions apply when (P, A) is greater than or equal to 0 such that the market demand of A should be greater than 0 and market demand of P should be greater than 0.
  • Variable costs of production can be thought of as the function of C (D (P, A)) where costs are greater than 0.
  • Put all those assumptions together,
  • Monopolist’s profit function = P (D (P, A))– C (D (P, A))
  • First order condition where monopolist can maximize their profit
  • ΠP = (P − C′)DP + D = 0, where PM (A) is the profit-maximizing price
  • ΠA = (P − C′)DA − κ = 0, where AM (P) is the profit-maximizing advertising level
  • Combine those two questions above, the monopolist can find the optimal level for both price and advertising:
  • (PM, AM) = (PM (AM), AM (PM))
  • Elasticity of price (εP) = - P * Dp /D
  • Elasticity of advertising (εA) = A * DA/D
  • Mark-up rule can be obtained from the first order conditions equations
  • (P – C’) / P = 1 / εP
  • Marginal revenue that arises from one dollar rise in advertising costs
  • P * DA / K = εP
  • The optimal advertising level can then be denoted as
  • KA / PD = εA / εP

The main shortcoming of this model is that while it helps to explain the behavior of consumers in response to monopolist advertising, it fails to provide a probable cause of that behavior.

In the end, the Dorfman and Steiner model helps to explain that when considering all other factors constant and equal, when εP gets smaller and smaller, indicating a more inelastic price demand function, in order to have a profit maximizing function, the monopolist would respond by increasing the “advertising intensity” and create a “large mark-up” (Bagwell 2007).

Bagwell, K. (2007). Chapter 28 The Economic Analysis of Advertising. Handbook of Industrial Organization, 3, pp.1701-1844.

Advertising Intensity edit

We can derive an 'advertising to sales ratio' to try to find the optimal level of advertising in competition.

  • Assume that a change in advertising leads to a shift in the demand curve
  • Two elasticities are important: the advertising elasticity of demand (η) and the price elasticity of demand (ε)

The firm has a constant marginal cost and their demand is dependent on the price (p) and amount spent on advertising (a), q(p,a):

π = (p − c)q(p, a) − a

First Order Conditions:

(p − c)(∂q / ∂a) = 1

Multiply both sides by (a/R), where revenue is R = p*q(p,a):

((p − c)/p)*((∂q/∂a)*(a/q))=a/R

Combine with Elasticity Rule:

((p − c)/p) = -(1/ε)

To get 'Advertising to Sales Ratio':

a/R = η/-ε

Through this we see that the optimal level of advertising should be the same as the ratio of elasticity of demand with respect to the advertising elasticity of demand with respect to the price. This is known as the Dorfman-Steiner condition. More should be spent on advertising when the demand of price is inelastic. More should be spent on advertising when advertising demand is elastic.

  • Advertising can soften price competition - this can happen when advertising product characteristics increases product differentiation and consequentially softens competition. High amounts of product differentiation can lead to monopolistic competition.
  • Advertising can intensify price competition - advertising can transform the 'tourist trap model' into a 'Bertrand model'. In many circumstances, advertising price in particular increases price competition.

Conclusion: edit

  • In the equilibrium, the price, advertisement and profit level of the manufacturer of high-quality products are higher.
  • The higher the degree of vertical differentiation is, the higher the enterprises's price is in equilibrium, and the more advertisements it makes, the greater its profit will be.
  • The higher the cost of advertising, the less advertising, the higher the price and the larger the profit.

Since advertising informs more consumers about the existence and/or usefulness of the product, as advertising spending s increases, so does demand and profit. As a result, firms select advertising to maximise profit by determining where the marginal revenue from advertising is equal to the marginal cost of advertising. Unlike the Crowd Appeal Model, in the Informative Advertising Model higher levels of advertising do not lead to higher prices. However, an increase in advertising does increase consumer surplus as well as firm profit, since advertising increases the number of consumers that get a surplus. In a nutshell, the higher levels of advertising leads to more consumers but not higher demand for each consumer, thus, prices are not affected and leading to an increase in market efficiency.

Asymmetrical Information edit

Theory of asymmetrical information proposes that a lopsided information between buyers and sellers results in sellers promote low quality products deliberately, for the value difference between good products and bad products are generally larger than the actual payoff of selling good products. In the end, asymmetrical information will probably lead to a reduction in average market quality and the market size because buyers will be reluctant to purchase goods from the market.

In 2001 George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz shared the Nobel Prize in economy “for their analyses of markets with asymmetric information”. (Nobelprize) [5]

Akerlof uses two steps below Market for Lemons to explain asymmetrical information (George A. Akerlof, 1970) [6]

1.Market for Lemons

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market.

2.The Automobile Market

Suppose in a used-car market, there are only four types of cars: New cars and used cars, good cars and bad cars. A new car can be a good car or lemon, and this is also true for a used car.

A buyer wants to buy a new vehicle without knowing whether the vehicle is good or a lemon. But the buyer does know the probability q for a good car whereas (1 - q) for a lemon. After a length of time, the buyer will be able to more accurately estimate the quality of his car than original estimate, which enables him to assign a new probability to the case that the car is a lemon. An asymmetric information has then been developed, for the seller have more knowledge of the car’s situation than the buyer. In this case, it is obvious that a used car will not be valuated the same as a new car and therefore, to trade a lemon at the price of a new car and buying another new car with higher probability q of being a good car and lower (1 - q) of being a bad car will be no doubt favourable if they are of the same valuation. Thus, owners of good cars will be locked in since they can neither receive the true value of their cars nor acquire expected value of a new car.

Under Gresham's Law, bad cars tend to drive out good cars (legally overvalued currency will tend to drive legally undervalued currency out of circulation)(Jim Chappelow, 2019)[7]

However, the analogy is not complete in our case:

  • Bad cars drive out good cars because they are sold at the same price.
  • Bad currency drives out good currency because their exchange rate is equal.

The difference between these two is that investors can distinct bad and good currency in Gresham’s law, but buyers cannot tell the difference between good and bad cars not before after some time under information asymmetric. As a result, Gresham’s law reveals the result, but it is not complete theoretically.

3.Asymmetrical information

It is foreseeable that lemons can drive out good cars from the market. Nevertheless, in markets with multiple product grades, morbid results could have happened: bad expels not quite bad expels middle expels not quite good and at last, expels good, which circumstance is not existing in any markets.

To argue this, we can suggest that demand (Qd) for second-hand cars depends on:

  • p, Price
  • σ, Average quality

so Qd = D(p, σ)

The supply (S) and average quality of second-hand cars (σ) depend on price (p), so:

  • S = S(p)
  • σ = σ(p)

At last, the equilibrium between supply and demand can be concluded as:

D(p, σ(p)) = S(p), σ(p) may possibly fall after p falls.

Assume there are two groups of buyers with given utility function respectively:

  • U1= C + ,
  • U2= C + 

where C is the consumption expect buying used cars for both groups, N is the number of cars and xi is the quality for number i car.

And assume following conditions:

  1. Both groups are Von Neumann-Morgenstern maximizers who tend to maximize their utilities.
  2. Group 1 owns n cars with qualities distribute uniformly from 0 to 2, xi ∈ [0,2], while group 2 has no cars.
  3. C is an invariable.

Suppose the income of group 1 is Y1 and the income of group 2 is Y2, all the consumption including used cars will be covered in income, demand and supply of group 1 will be:

  • If σ/p >1, D1= Y1/p
  • If σ/p <1, D1= 0
  • If p∈ [0,2], S1= σ n, where σ= p/2 (see 2)

Demand of group 2 will be:

  • If 3σ/2 > p, D2= Y_2/p
  • If 3σ/2 < p, D2= 0
  • S2= 0 (see 2)

The total demand will be the aggregate demand of group 1 and group 2:

  • If σ > p, D= (Y1 + Y2)/2
  • If 3σ/2 > p, D = Y2/p
  • If 3σ/2 < p, D = 0

Because σ= p/2, theoretically no deals will be made for D = 0. As a result, an asymmetrical information can lead to a break down of a “Lemon market”.

In conclusion, under asymmetrical information, uncertainty like Market of Lemons will lead to a situation like prisoner dilemma, where two individuals trying to maximize their own benefits and fail to acquire optimal payoff in the end.

The opposite of asymmetric information is 'symmetric information' and occurs when both parties have equal knowledge.

Problems due to Asymmetric information:

Adverse selection: Occurs when one party to a transaction possesses information about a hidden characteristic that is unknown to other parties and takes economic advantage of this information before a transaction.

An example of adverse selection occurring in the real world could be the tendency for those involved in high-risky lifestyles and dangerous jobs to purchase life insurance. In this case it is the buyer who has more knowledge (e.g. their level of health ) about the transaction. Insurance companies understand this and combat it by reducing exposure to larger claims by raising premiums and limiting coverage.

Consumers may not make purchases to avoid being exploited by better-informed sellers. As a result, not all desirable transactions occur, and potential consumer and producer surplus is lost.

Moral Hazard: An informed party takes an action that the other party cannot observe that harms the less informed party. Thus, immoral behaviour may rise when well-informed party takes advantage of asymmetric information after the transaction (e.g. if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance).

Examples of moral hazard include salesperson compensation and government bailouts. When a business owner pays a salesperson a set of salary not based on sales performance, the salesperson has less motivation to put forth less effort, take longer breaks, and generally have less motivation to make more sales than if the compensation is tied to performance. In terms of government bailouts, the management of corporation may take more risk in pursuing profit if they believe the company will receive financial bailout from the government to keep it going. the government safety nets generate moral hazards, leading to more risk-taking behaviors and consequences of unreasonable markets.

How Can Advertising Signal Quality? edit

When a company advertises a product using an expensive advertising campaign, consumers may infer that the advertised product is of high quality as only firms of high quality are able to afford such a campaign. On the contrary, firms of lower quality are unable to do so or achieve the same standard of advertising due to the lack of resources, that are associated with a high quality firms. Additionally, there is a misconception that price is used as a reference point for consumers to infer the quality of a product, the higher the price, the better the quality. However, research has shown that this is not always the case. An example would be blind taste testing for wine. It has been shown that there is no correlation between the price of wine and quality of wine.

Seeing how much a company spends on advertising can be a form of information on the product quality. By perception, knowing that a company spends more on their advertising campaigns can bring about an interest in the consumers to try the product due to higher perceived quality. It was found that once consumers try the product and gain value from it, and their marginal benefit exceeds their marginal cost, they will continue purchasing the product and that profit will offset the high costs to create an expensive advertisement.

Interestingly, the actual content of the advertisement was found to be unimportant as compared to how much was spent on the advertisement. Consumers know that advertising is costly and thus the information provided to them is not the content but instead the fact of its high expense and existence.

Different forms of advertising can lead to different effects on prices and consumer demand. Advertising as crowd appeal can lead to higher demand for each consumer, which will then lead to increased prices. Advertising as information leads to more consumers but not higher demand for each consumer, therefore prices are not affected by advertising levels.

Advertising as a Complementary Good edit

Advertising can help increase the value of a good. Firms advertise to increase the demand for the primary good. When firms utilise advertising as a complementary good, it may be persuasive enough to increase consumers' value perception. The advertising done by the firm will then be incorporated into the value of the primary good as perceived by consumers.

Advertising as a signal of quality edit

As there are cost associated with the production of advertising, firms' products can be perceived by consumers as being good or bad quality based on the perceived value of the advertising campaign. A company who can afford an expensive ad campaign is perceived by consumers as having good quality products. While an ad campaign perceived have a low budget may be inferred to as being a poor quality product. When celebrities and athletes are used for ad campaigns, their involvement in the advertisement acts as a signal of quality as they endorse the products they are advertising. For example, NBA player Stephen Curry partakes in many Under Armour campaigns wears their shoes to play in thus acting as a signal of quality to the consumers.

High quality companies only engage in advertising if there is a new product being launched, yet they never continue to advertise that particular product once it is has been introduced into the market. These high quality firms also tend to (gradually) increase prices over a certain period time. In retrospect, low quality firms maintain their prices over time and never participate in wasteful advertising. (Macdonald, 2003) [8]

Advertising as a sunk cost edit

Sunk costs are often thought of as exogenous setup costs. However, advertising is an endogenous sunk cost that results in increased demand for a firm's product and may be necessary for the firm to enter and compete in a market (Bagwell, 2007). This assumes that

1. Advertising in a market increases consumers' willingness-to-pay

2. Sufficiently high willingness-to-pay guarantees a minimum level of profit in the next competition period (that is, the cost of advertising does to not increase too quickly with consumers' willingness-to-pay)

Views on Advertising edit

Economists have long been trying to understand why consumers respond to advertising. Through an effort to understand the consumer mindset to answer this question, three main views on advertising have emerged. These views, as defined by Kyle Bagwell in 2007 (Bagwell, 2007) are as follows;

1. Persuasive View

The Persuasive View is the idea that advertising aims to affect the demand of a product by altering consumer preferences and in-turn, creating an illusion of product differentiation and brand loyalty in the process. An example of this is the difference between brand name and generic compounds of the same drug. Although the active ingredients in the drug are identical, consumers are more likely to believe that the brand name drug is more effective and thus more likely to pay for it even if it is more expensive. It is for this reason persuasive advertising can make the demand of a firm’s product more inelastic, leading to a mark-up in price and consequently allow them to generate higher profits. In addition to this, the persuasive approach implies anti-competitive effects in certain markets. For established firms, advertising can act as a deterrent to potential entrants and may result in highly concentrated markets where firms are able to subject consumers to high prices.

2. Informative View

The informative approach holds the idea that markets contain imperfect consumer information and search costs which may deter consumers from purchasing certain products. This view identifies advertising as the solution to this problem, providing the consumer with the information required to identify and purchase products they otherwise would not have. As a result, the advertising firms demand curve may become more elastic, promoting competition between other firms in the market. Additionally, this view implies advertising facilitates market entry by allowing new entrants to publicise their product/existence and attract new consumers. Essentially, the informative view implies that advertising has pro-competitive effects as opposed to the persuasive view which stated the opposite.

3. Complimentary View

The complementary view implies that advertising makes no attempt to persuade potential consumers to change their preferences, but rather that it uses the predefined taste of consumers to build upon to offer consumers more of something they already value. An example of this could be a firm advertising a product that offers prestige aimed at consumers who already value and aim to increase their social prestige.

Negative Views on Advertising edit

Advertising has both positive and bad effects to a product or a company. There are negative views associated with advertising that a firm must consider. These include:

1. Advertising as product differentiation
Firms use advertising to lure consumers to buy a certain product. Advertisements can be used to differentiate a certain brand of product to another brand. and make demand for the good/service more price inelastic However, sometimes advertisements create unrealistic expectations for customers. People are drawn to new technology and firms know this. Many technology companies over-hype the groundbreaking nature of the technology in order to draw in new customers before completing the necessary research and development to deliver.

2. Advertising as a barrier to entry
Advertising can serve as a barrier (e.g. sunk cost) for other firms to enter the market. Advertising expenditures can promote market power which allow the firm to overcharge and potentially lead to market inefficiencies (for example: high prices and restricted output in the market). Hence, policies are needed to prevent such negative impacts on market structure.

Smaller firms looking to enter the market do not have enough resources to put into advertising. Therefore, they cannot gain enough market power and are unlikely to become sustainable. Since new entrants are unlikely to enter the market and the market is dominated by more established, large players, perfect competition in the market is not possible. Market will begin to resemble an oligopoly or even a monopoly if there is only one large player in the industry. Thus, there will be an erosion of consumer surplus as large players can heavily influence the price of the goods/service. While very beneficial to incumbent firms, this is detrimental to society as a whole from a policy perspective.

3. Advertising game as a prisoner's dilemma.

An example of prisoner's dilemma in the business world is when two firms (i.e. competitors) are battling in the market. Often, many business have rivals. For example, Woolworths and Coles are two main rivals in the industry. If Woolworths advertised its products as low priced, Coles has no choice but to follow. Both firms have no idea what the other rival will decide and what to advertise in the future. Another example is Cola-cola and Pepsi launching advertise campaign, this may lead to misallocation of resources as the advertising functions can be neither informative nor persuasive, because those products are already well-known and letting customer switching between those firms do not create extra surplus but potentially lower total profits received by both firms.

Thus, advertising may lead to a wastage of resources depending on the actions of competitors. Firms would be better off coordinating their actions by both players committing to not advertise. However, this is not realistic especially in a market with many different players. Furthermore, it is not possible to hold the other player responsible if the other player decides to advertise despite the prior agreement. There are no dominant strategies for either player and no Nash equilibrium. Nash equilibrium is when neither player has an incentive to deviate from the equilibrium state.

Impact and Consequences of Advertising Restrictions edit

Effective advertising has a significant influence on consumers and how much they consume. When consumption results in health problems, ethical issues, and other epidemics alike, governments have been active in limiting these issues through bans and restrictions of advertising in order to limit harmful threats to society. The following sections will address how these restrictions affect the market. For the purpose of context, there will be an emphasis on the effects of banning advertising in the junk food market.

Upon issuing a ban on advertising in a market, the effects of intervening can be diverse depending on the motive which drives advertising in the market. Firms tend to engage in advertising to either expand their market share or take from other rival firms in the market. In the situation where junk food advertisement is banned and prices remain fixed, it is expected that demand will decrease. Ultimately resulting in a tilt in the consumer demand curve and alter the consumer’s willingness to pay for a healthier option. Therefore, this reduction in the demand curve facilitates a more competitive market, leading to reactive firm behavior in a capacity of lower prices. Studies have shown that through the banning of advertisements of junk food, the consumer’s choice within the market can be manipulated in order to achieve more desirable and healthy eating behaviors. It has been established that reduction of advertisement induces the switch from foods considered “unhealthy” to more “healthy” alternatives through a shift in the weight of the consumer’s perception of nutritional characteristics of products.

Whether and How Much to Advertise edit

Successful advertising campaigns attract customers and generate sales by spreading the word about a businesses products and services. The best advertising option for a business depends on their target audience and the most cost-effective way of reaching them. For advertisements to be effective and profitable they must be placed in the right environment for the product or service being advertised.

  • Advertising may help in shifting a product demand. However, this may not pay for the cost of advertising. Advertising can pay the cost of advertisement only if it increases the expected net profit of a firm. Net profit is the gross profit minus the cost of advertising.
  • The degree to how much a firm must advertise depends when marginal benefit is equal to its marginal cost. Marginal benefit is the extra gross profit from one more unit of advertising or the marginal revenue from one more unit of output.

Shift in the Marginal Benefit of Advertising

  • A special event will cause a regular viewer to watch another show instead of infomercials

Does Advertising Work? edit

In terms of statistics, it is difficult to know if an advertisement was efficient (and how efficient it was) for multiple reasons. First of all, it is quite difficult to know what made a consumer click on a certain ad. For example, if someone googles a product they intend to buy and find an ad, if they click on it the website would assume the consumer bought the product thanks to the ad when they initially intended to buy the product, regardless of the ad. Another difficulty that occurs when trying to gage the efficiency of an ad is the timing gap. An advertisement can take time before having an effect on consumers (for example because they don't need the product at the time of the advertisement, but they do later on). The timing gap could be substantial, and this makes it hard to know which advertisement worked on consumers.

Firms spend around $500 on advertising per person each year. The U.S Small Business Administration also suggests that firms spend between 7 to 8 percent of their revenues on advertising. To break even expenditures on advertising, households should spend between 3500 to 5500 per year on advertised products. However, to e more accurate, one should measure the consumer behaviour and examine whether advertising affects consumer choice or no.

Measuring the returns to advertising is not an easy thing to do. RCTs suggest the median confidence interval on return on investment is over 100 percentage points wide. Furthermore, relative to the per capita cost of the advertising, individual-level sales are very volatile; a coefficient of variation of 10 is common. The relationship between people’s spending and what they buy is very ambiguous. However, advertising might be counted as contributor factor that could possibly shift consumer choices into a specific direction. In terms of statistics and given the variations in what people buy, it is very complex to find an accurate relationship between those patterns.

How do we know whether the advertising campaign was successful?

  • If you want to measure the success of a campaign, the goals have to be defined in detail prior to the start of the campaign.
  • Define the target audience, objectives and user context.
  • Generally speaking, in regards to the performance of a campaign, marketers or campaign analysers look at metrics that are associated with increased sales, increased profitability or having an impact on the customer experience with the company.

Dubois P et al. (2017) studied the effects of banning advertising in junk food markets. A ban on advertising foods that were high in fat, salt or sugar during children's programming was conducted and studied the effects on expenditure and quantity and how they compared after a ban with a price response and no price response. "No price response" refers to the situation where prices were held at their pre ban level and with a "price response" firms re-optimised their prices. Expenditure refers to total expenditure on potato chips and quantity refers to the total amount of potato chips sold. The study found that expenditure declined by 15.10% with no price response and 13.62% with a price response. Along with a decline in expenditure, quantity also decreased by 15.24% with no price response and 9.72% with a price response.

Economic Effects of Advertising edit

Advertising plays an important role in the economy. It helps to provide customers with useful information that allows them to increase their knowledge about the product of service all while comparing the price, features and benefits with other competing products. Advertising also creates an economic chain reaction that can causes three things:

  • Generate a net gain in direct sales and jobs due to the promotion of the industries’ products and/or services
  • Generate indirect sales and jobs due to the promotion of the industries’ products and/or services, and;
  • Generate indirect sales and jobs among the first level suppliers to the industries that incur the advertising expenditures

Similarly, advertising plays an important role in a business cycle. While the economy goes through its bull and bear cycles, advertisers shift their focus. For example, during a recession, advertisements tend to focus on how their price compares to the market price. Furthermore, if one company chooses to decrease their advertising budget, another company may increase their budget in order to gain a greater market share.

In an economy dependent on consumer spending, advertisements assist to stimulate its economic growth. Advertisements initiate a chain reaction in fiscal stimulus where by once viewed, consumers spend more. Effects are observable through an increase in productivity, which then create jobs to match the demand for the good.

Direct and Indirect Effects of Advertising edit

According to Bagwell (2007), a firm's advertising has various direct and indirect effects, which are used as evidence and termed under empirical regularities.

The direct effects of advertising edit

The direct effects of a firm's advertising can be viewed in terms of its current and future sales, the sales of competing firms and the brand loyalty of its consumers, and finally, the presence and absence of advertising scale economies.


Studies show three conclusions in relation to the effects of a firm's advertising and its sales. Firstly, a firms current advertising is correlated with an increase in its sales; however, this effect is often short-term. Advertising effect also varies depending on the competitive positioning of the firm. Incumbent advertisers who increase their sales can detract from sales of their competitors. The result can be combative, where the competitor can respond by increasing their level of advertising intensity to regain lost sales. However, firms that can undercut their rivals by achieving advertising economies of scale can seize a significant market share and hence increase sales.

Brand loyalty and market-share stability

The persuasive view of advertising suggests that advertising can create brand loyalty, and hence can increase the market power of incumbents. As a result, advertising can decrease the demand elasticity of the advertised good.

The indirect effects of advertising edit


Larger companies who can spend more on advertising have a clear cost advantage over smaller firms, and hence acts as a barrier to entry.

There are two main arguments for how advertising scale economy advantage can arise.

  1. The marginal cost of advertising falls as advertising intensity increases.
  2. The higher brand equity in large firms makes advertising expenditure more effective, as their intensity would already be greater than their smaller competitors.

Price and Profit  

Both the Crowd Appeal Model and Informative Advertising Model show that there is a positive correlation between the amount spent on advertising (as a proxy for advertising intensity) and a consumer’s willingness to pay (which will increase consumer surplus). Hence firms can set the price of the advertised good higher.  

Firms will consequently use advertising to set their prices to maximise profit.

Hence, greater advertising intensity increases prices and firm profits.


Increased advertising intensity within an industry has an ambiguous empirical effect on entry into the market.

Several studies suggest that advertising deters new entrants as  advertising increases the cost of entry, as first-movers have a cost advantage from already having built brand equity [9].

However, for industries where new innovations are common, advertising can lessen the cost of entry as a differentiated and innovative product can garner interest with low advertising expenditure.

Summary edit

This section briefly summarises the key points from this topic.

Search Good: A good or service that has characteristics that can be easily determines before purchasing. A consumer knows the value they will receive from the good before buying. Complemented by Informative Advertising, which clearly outlines the value consumers can expect from the good.

Experience Good: A good or service where the characteristics are difficult to observe before purchasing but realised upon consumption of the good. A consumer only realises the value of the good after buying. The Crowd Appeal model of advertising can be applied by firms to leverage the base of existing users to convert apprehensive buyers.

Credence Good: A good or service where the characteristics are difficult to observe after purchasing. A consumer is unsure what the value of the good is after buying it. A combination of Informative and Persuasive Advertising can be applied in tandem to respectively inform consumers of the benefits conferred by a product and convince them of the value proposition even where the results are not as tangible or obvious.

Type of Good Advertising Rationale
Search Informative Opportunity to inform consumers and clearly outline the value consumers can expect from the good.
Experience Crowd Appeal Leverage the base of existing users to convert apprehensive buyers
Credence Informative / Persuasive Applied in tandem to respectively inform consumers of the benefits conferred by a product and convince them of the value proposition

  • When searching for goods in the market there is always a cost incurred usually in the form of time spent.

Search Costs: The cost of finding information on the good or on the good's alternatives.

Tourist Trap Model: The tourist trap model depicts a situation in which tourists incur greater costs on a good due to their limited information. They are more likely to be overcharged in this model.

  • Asymmetric information in trading introduced problems such as adverse selection, where a party uses private information to gain an economic advantage in the trade, and moral hazard, where someone is more inclined to make a risky transaction because the negative outcome doesn’t completely fall on them.
  • Advertising for products is an effective marketing tool that can be applied through multiple medias, advertising aims to reduce the search cost of goods and involves informing customers of the product while influencing consumer perception to increase product value. There are three types of advertising, informative, persuasive and complimentary.

Monopoly Advertising: Occurs when a monopolist firm has the power to choose the type of advertising that is most beneficial to their firm.

Reference/s edit

  1. Bagwell, K. (2007). The economic analysis of advertising. In Handbook of industrial organization (pp. 1701–1844).
  2. Bagwell, K. (2007). Chapter 28 The Economic Analysis of Advertising. Handbook of Industrial Organization, 3, pp.1701-1844.
  3. Bagwell, K. (2007). Chapter 28 The Economic Analysis of Advertising. Handbook of Industrial Organization, 3, pp.1701-1844.
  4. 4.0 4.1 Moorthy, S. & Hawkins, S.A., 2005. Advertising repetition and quality perception. Journal of Business Research, 58(3), pp.354–360.
  6. George A. Akerlof, (1970). The Market for "Lemons": Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, Vol. 84, No. 3 (Aug., 1970), pp. 488-500.
  7. Gresham's Law (2019).
  8. Macdonald, I. H. (2003). Is advertising a signal of product quality? Evidence from the compact disc player market 1983-1992. International Journal of Industrial Organization, 317-345.
  9. "This Week's Letters". Science 303 (5666): 1974a–1974a. 2004-03-26. doi:10.1126/science.303.5666.1974a. ISSN 0036-8075.