8 Advertising

Advertising is a widely observed phenomenon in most markets.

Developed countries spend more than 2 percent of GDP on advertising.

There is a huge variation in the advertising/sales ratio across di¤erent

industries.
Three di¤erent views on advertising

1. Advertising is persuasive. It changes consumers’preferences and creates

brand loyalty.

2. Advertising is informative. It informs consumers about the existence,

characteristics and prices of products.

3. Advertising is complementary. It enters as a separate argument in con-

sumers’utility functions (e.g, advertising can increase a consumer’s "social
image" of consuming a particular product).
8.1 Price and advertising decisions by a monopolist

How much should a …rm spend on advertising its product?

Consider a monopoly …rm selling a product in a market with demand

Q (p; A), where A is the …rm’s expenditure on advertising and p is the
price of the product .

The unit cost of production is c:

The …rm’s choice variables are A and p:

The monopolist faces the following problem:

max = (p c) Q (p; A) A:
A;p

The …rst-order condition for the optimal price level is

@ @Q
= Q + (p c) =0
@p @p
()
p c 1
= ;
p "p
where
@Q p
"p =
@p Q
is the price elasticity of demand.
The …rst-order condition for the optimal spending on advertising is
@ @Q
= (p c) 1 = 0:
@A @A

Using the condition p p c = "1p :

@ p @Q
= 1 = 0;
@A "p @A
which can be rewritten as
p Q
"A 1 = 0;
"p A
where
@Q A
"A =
@A Q
is the elasticity of demand with respect to advertising expenditures.
Finally, we can rearrange the optimality condition to get
A "
= A:
pQ "p

This condition is known as the Dorfman-Steiner condition:

– The optimal advertising/sales ratio is proportional to the advertising

elasticity relative to the price elasticity of demand.
Examples of advertising intensities in selected US industries - 2011

Markets A=pQ
Transportation Services 24.6%
Perfume & Cosmetics 20.0%
Distilled & Blended Liquor 14.3%
Soap, Detergent, Toilet Preps 12.1%
Education Services 10.7%
Rubber & Plastic Footwear 10.6%
Special Clean, Polish Preps 10.1%
8.1.1 How does advertising a¤ect the price elasticity of demand?

How does the properties of Q (p; A) depend on the type of advertising?

A simple discrete-choice model

There is a continuum of consumers with total mass equal to 1.

Each consumer buys at most one unit of the product.

Consumers vary in their intrinsic valuation of the product, given by ,

which is uniformly distributed on [0; 1].
Suppose that advertising is persuasive

– Consumers’intrinsic valuation of the product is in‡ated such that the

willingness to pay is given by g (A) , where g (0) = 1 and g 0 (A) > 0:

p
– A consumer is willing to buy one unit if p g (A) , g(A)
.

– Demand is therefore given by

p
Q (p; A) = 1 ;
g (A)
and the price elasticity of demand is given by
@Q p p
"p = = :
@p Q g (A) p

– Persuasive advertising makes demand less price elastic and therefore

increases the monopoly price.
Suppose that advertising instead is informative.

– Consumers need advertising to get informed about the product.

– An informed consumer is willing to buy if p.

– Each consumer is informed with probability f (A) 2 [0; 1], where

f 0 (A) > 0.

– Demand is then given by

Q (p; A) = f (A) (1 p) ;
and the price elasticity of demand is
@Q p p
"p = = :
@p Q 1 p

– Informative advertising has no e¤ect on the price elasticity of demand.

8.2 Advertising and competition

The e¤ects of advertising on price competition are likely to crucially depend

on whether the advertising is predominantly informative or persuasive.

8.2.1 Informative advertising

Informative advertising is likely to make demand more price elastic and

therefore to intensify price competition.
Simple example

Consider a duopoly with homogeneous products.

– Each consumer has a maximum willingness-to-pay of v for the product.

– Suppose that consumers don’t know the prices charged by the …rms,
and have time to visit only one of the …rms to check the price.

– Without advertising:

Since consumers have no information about prices, their best strategy

is to choose one …rm at random, check the price, and buy the product
if p v .

Knowing this, the …rms optimally set their prices equal to the maxi-
mum willingness-to-pay: p = v .
– With advertising:

If the …rms advertise their prices, consumers will be able to compare

prices without visiting the …rms.

If all consumers learn about the prices through advertising, we have

a situation like the Bertrand model (with homogeneous products)
with equilibrium price equal to marginal cost.
A richer model

Consider a Hotelling model where a total mass of m consumers are uni-

formly distributed on the Hotelling line with length equal to 1.

Two single-product …rms are located at each end of the Hotelling line:

– Firm 1 is located at the left endpoint.

– Firm 2 is located at the right endpoint.

Consumers are initially uninformed about the existence of the products in

the market and rely on advertising to become informed.
The two …rms send out ads that reach consumers randomly.

– Let a1 be the probability that a consumer receives an ad from Firm 1.

– Let a2 be the probability that a consumer receives an ad from Firm 2.

Consumers who receive an ad from only one …rm will buy the product from
this …rm.

Consumers who receive no ads will not buy.

Consumers who receive ads from both …rms will choose which product to
buy based on price and transportation costs (t per unit of distance).
The …rms have equal and constant marginal production costs equal to c.

The cost of advertising for Firm i is given by ka2i =2, where k > 2t .
Demand

For given values of a1 and a2 there are three di¤erent demand segments:

– A competitive segment: the a1a2m consumers that have received ads

from both …rms.

– A captive segment: the a1 (1 a2) m consumers that have received

an ad only from Firm 1; and the a2 (1 a1) m consumers that have
received an ad only from Firm 2.

– An uninformed segment: the (1 a1) (1 a2) m consumers that

have not received any ads.
Demand for the two …rms are then given by

b + a1 (1
D1 = (a1a2x a2)) m;

D2 = (a1a2 (1 b ) + a2 (1
x a1)) m;
b is the location of the indi¤erent consumer in the competitive
where x
demand segment, given by

b = p2 + t (1
p1 + tx b) ;
x
or
1 p1 p2
b=
x :
2 2t
Competition

Suppose that the two …rms simultaneously choose prices and advertising.

Pro…ts for Firm 1 are given by

k 2
1 = ( p1 c) D1 = (p1 b + a1 (1
c) (a1a2x a2)) m a1:
2

The …rst-order condition for the pro…t-maximising price is

@ 1 1
= a1 1 a2 + a2 (t 2p1 + p2 + c) m = 0;
@p1 2t
which yields the best-response function
p + c + t 1 a2
p1 = 2 + t:
2 a2
The …rst-order condition for the pro…t-maximising level of advertising is
@ 1 1
= (p1 c) 1 a2 + a2 (t p 1 + p2 ) ka1 = 0;
@a1 2t
which yields the best-response function
1 1
a1 = (p1 c) 1 a2 + a2 (t p1 + p2 ) :
k 2t
Nash Equilibrium

In the symmetric Nash equilibrium, p1 = p2 = p and a1 = a2 = a .

Substituting into the best-response function for the price yields

2 a
p =c+ t:
a

A higher equilibrium advertising level implies a lower equilibrium price.

Informative advertising is pro-competitive!

Substituting p1 = p2 = p and a1 = a2 = a into both best-response
functions and solving, yields
p 2
p =c+ 2kt and a = q :
1+ 2k
t

Since k > 2t , a < 1 and p > c + t:

The price is higher than if all consumers were informed.

Lower advertising costs increases advertising and reduces the price.

Equilibrium pro…ts are given by
1
p
2k @ 2 2
= q 2
; which implies = q 3
> 0:
@k p
1 + 2k
t
k+1 2
t 2

Equilibrium pro…ts increase if advertising is more costly!

Two counteracting e¤ects:

1. For a given advertising level, higher advertising costs reduce pro…ts.

2. But higher advertising costs lead to lower advertising, which in turn

increases pro…ts.
8.2.2 Persuasive advertising

Suppose that each …rm can use persuasive advertising to increase the per-
ceived degree of horizontal di¤erentiation between its own product and the
product of rival …rms.

A simple way to capture this idea in the Hotelling model with two …rms is
that the transportation cost per unit of distance is given by

t (a1; a2) = t + a1 + a2;

where t is the transportation cost without advertising and > 0 is the
marginal e¤ect of advertising on the perceived degree of product di¤eren-
tiation.
In the standard Hotelling model, the equilibrium price and pro…ts are given
by
p = c + t;
t
= :
2

Replacing t with t (a1; a2), the equilibrium price becomes

p =c+t+ (a1 + a2) :

More advertising increases the price.

Persuasive advertising is anti-competitive!

Replacing t with t (a1; a2) and subtracting the cost of advertising, equi-
librium pro…ts for Firm i are
t+ (a1 + a2) k 2
i = ai :
2 2

If …rms choose advertising before price, the optimal advertising level is

given by
@ i
= kai = 0;
@ai 2
implying

a = :
2k
The equilibrium price and pro…ts are
2 t 3 2
p =c+t+ ; = + :
k 2 8k

Higher advertising costs lead to lower prices and pro…ts.