Vol IChap 22CompetitionLaw_m1

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Chapter 22

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ADVERTISING AND COMPETITION

Anthony J. Dukes

This chapter provides an introduction to the economic analysis of advertising, providing

the foundation that is needed to understand how advertising relates to product

differentiation and to various antitrust theories that directly involve advertising. As

explained below, advertising is an important competitive tool that firms use to convey

information to potential purchasers about their products performance characteristics and

price. This makes advertising conduct an important market attribute.

1. Introduction

Advertising is an action throughwhich firms communicate to the public. It involves

a variety of content (e.g., specific product details, product comparisons, image

enhancement, and quality signaling) and media (e.g., television, radio, Internet, print,

product packaging, and direct marketing). The information that is communicated may

relate to the price of a product or other product characteristics. Information about

product quality may be very direct or it may be signaled by association with other

things, including the price of the product or particular people. In fact, economists have

come to understand that a firms decision to advertise may offer a signal that provides

information beyond the content of the advertisement.

While pricing is often the focus of economic analyses of competitive conduct, firms

also use advertising to compete. In fact, U.S. firms spent over $285 billion on

advertising in 2006,1over 2 percent of the gross domestic product (GDP).

2Given the

widespread use of advertising, it is not surprising that economists devote considerable

attention to studying advertising in the context of different product markets as well as to

studying advertising markets themselves. Economists have not only delved into why

firms advertise, but they have also studied the effect that advertising has on consumers

and onmarket performance. For example, economists have considered whether there is

too much or too little advertising.

As suggested above, economists recognize that different types of advertising convey

different types of information. Some advertising is designed to convey information

about the price of the product or its availability at certain locations. However, much

advertising is devoted to providing information about a products quality or trying to

persuade customers that a particular product would bring a variety of benefits, including

a desirable image.

Marshall School of Business, University of Southern California. The author gratefully acknowledges

the helpful comments of Gregory Gundlach, David Soberman, and especially Philip B. Nelson.

1. 100 Leading National Advertisers, ADVERTISINGAGE, June 25, 2007.

2. Based on nominal gross domestic product of $13.25 trillion for 2006. See Press Release, Bureau of

Economic Analysis, United States Department of Commerce (June 28, 2007).

Anthony J. Dukes, Advertising and Competition, in ISSUES IN

COMPETITION LAW AND POLICY 515 (ABA Section of Antitrust Law

2008)

516 ISSUES IN COMPETITION LAW AND POLICY

Because advertisers themselves decide on the content of advertisements, consumers

take information that is provided through advertisements with a grain of salt. As a

result, economists have sought to determine how consumers interpret advertisements

and to evaluate how they are affected by advertising. Illustrative questions that

economists have considered include: Does the mere fact that a product is advertised

signal to consumers that the product is a quality product? Does exposure to advertising

make consumers more or less price elastic? Can advertising ever be used to confuse

consumers?

By answering these types of questions, economists have developed an understanding

of how advertising works that provides insights into various public policies, including

antitrust law. In particular, because advertising can inform customers about market

prices, agreements that restrict advertising can have significant anticompetitive effects

on price by reducing the elasticity of demand that individual firms face. Because

advertising sometimes is an efficient source of information about product quality,

advertising can facilitate entry by allowing entrants to more quickly inform customers

about their new products, allowing the entrants to avoid the slower and more costly

experience-based diffusion of quality information. On the other hand, intensive

advertising may indicate that entrants must invest significant sums in advertising before

they can compete successfully in a market, implying that themarketmaybe insulated by

sunk cost barriers to entry.

This chapter reviews the economics literature that has analyzed advertising aswell as

its relationship to competition,3providing a foundation for the analysis of the antitrust

issues that relate to advertising. Specifically, Section 2 elaborates on the role of

advertising in different market contexts. Section 3 discusses the economic incentives of

the individual firm with respect to its advertising decisions. Section 4 delves into the

strategic and competitive use of advertising. In particular, it analyzes how the

advertising of one firm may interact with the advertising of another firm and how

advertising may be used to differentiate a firms product so that the product is somewhat

insulated from rivals pricing. The section also discusses the state of empirical findings

with respect to advertising and competition.

Finally, Section 5 turns the inquiry toward the social impact of advertising. In

particular, this section explores the social benefits and costsnet social welfareof

advertising, and how they align with those of the firm. This permits us to identify

sources of market failure in the provision of advertising.

2. The roles of advertising

The definition of advertising employed in this chapter stems from the economics

literature. A great deal has been written on advertising, however, outside of economics,

most notably in marketing, psychology, and business management; definitions across

disciplines may vary. Prominent marketing texts, for example, that of Kotler and

Armstrong,4classify advertising under the more general business activity of promotion

3. For a broader review of the advertising literature, see Kyle Bagwell, The Economic Analysis of

Advertising, in 3 HANDBOOK OF INDUSTRIALORG. (Mark Armstrong & Robert Porter eds., 2007).

4. PHILIPKOTLER&GARYARMSTRONG, PRINCIPLES OFMARKETING (12th ed. 2007).

ADVERTISING AND COMPETITION 517

or marketing communication. The definition adopted here is that advertising is a costly

activity undertaken by the seller of a product and has an effect on the demand for that

product. The exact nature of this effect, however, has been the subject of discussion

among economists and is addressed in this section.

2.1. Classical roles

Economists typically view advertising as an activity that sellers undertake to inform

buyers about their products or persuade them that a product is most suitable. The value

of advertising and the type of advertising that sellers undertake is likely to be

determined, at least in part, by characteristics of the products that they are selling. In

particular, in their analysis of advertising, economists distinguish four types of products:

search goods, experience goods, credence goods, and conspicuous goods.

Search goods are products that consumers can fully evaluate before they purchase

them. For example, a consumer can inspect a shirt (for quality, fit, etc.) and accurately

anticipate its net benefit before buying. Economists refer to such products as search

goods because a consumer search is sufficient by itself to make an informed purchase

decision. For search goods, advertising is used to lower the consumers search cost by

informing the consumer about the products existence, helping the consumer locate

where it is available, identifying the price that must be paid at different locations, and

identifying product characteristics that vary across product offerings.

Economists have recognized that there are some products forwhich the consumption

benefits are not known until after purchase and trial and refer to these products as

experience goods. Economists sometimes distinguish between two types of experience

goods: convenience goods and shopping goods. Convenience goods are products for

which consumers cannot be sure of the quality until they consume it, but because the

product is low priced and purchased on a frequent basis, consumers are able to use

information from past purchases to make informed choices. Beverages are a good

example of this type of product. Because repeat business is important to suppliers of

convenience goods, suppliers have an incentive to provide stable quality levels so that

the consumers experience the same level of quality across their purchases. Given these

product characteristics, low-priced sampling of products is a cost-effective learning

strategy for convenience goods. Because suppliers want to encourage customers to

include their product in the sampling, they have an incentive to advertise to gain trial of

their product. The accuracy of claims made in these advertisements is subject to

repeated checks by consumers, which may lead consumers to become confident in the

accuracy of claims made by particular brands and thus more willing to try new

products introduced by those brands.5Moreover, with respect to an individual

convenience good, the stability of the product and the information provided byhistorical

5. While the information theory described in the text is central to much advertising literature, the reader

should be aware that there is some contradictory empirical evidence. For example, high prices have

sometimes been found to be associated with lower quality levels for convenience goods. See Peter

Riesz, Price-Quality Correlations for Packaged Food Products, 13 J. CONSUMERAFF. 236 (1979);

Alfred Oxenfeldt, Consumer Knowledge: Its Measurement and Extent, 32 REV. ECON. & STAT. 300

(1950).


trial may move the particular brand from having the characteristics of an experience

good towards having the characteristics of a search good and may force retailers who

resell these products to be careful about how they price them since comparison shopping

can be done relatively easily.

In contrast, shopping goods are high-priced goods that are purchased on an

infrequent basis. Automobiles are a good example of a shopping good. Because

sampling is not a cost-effective way for consumers to learn about these products,

economists have concluded that, in a comparative sense, consumers will make greater

use of the information and signals contained in advertisingwhen buying shopping goods

than when buying convenience goods.6However, because the detailed information that

consumers often demand before buying shopping goods can sometimes be provided

more cost effectively in other ways, such as through point-of-sale instruction by a

salesman, advertising levels are not always as high for these goods as onemight expect,

whichmay explain why Porter found that that the average outlay as a percentage of sales

was 4.7 percent for 19 convenience goods industries and only 2.1 percent for 23

shopping goods industries.7

Another category of goods are credence goods. The quality of these goods cannot be

fully assessed through trial, often because the utility of consuming these goods depends

in part on third-party reactions that are not easily assessed by the purchaser. For

example, suppose a bar patron buys a certain brand of beer to impress friends of his

refined taste in malt beverages. Beyond the enjoyment of the beer itself, added benefit

accrues to the purchaser because of what he believes others think of him. But since he

may never know howmuch his fellow bar-goers are impressed, he cannot be sure of the

benefit of the product even after consumption. For these goods, advertisingmaybe used

to reinforce the notion that a product will provide high levels of utility. In the beer case,

for instance, brand advertising conveys positive associations of those who drink the

beer. These associations are communicated, not only to the consumer, but also to his

friends.

The utility of consuming conspicuous goods, like credence goods, depends in part on

third parties reactions because these goods not only satisfy material needs but also

social needs such as prestige. Conspicuous goods include things such as jewelry,

perfumes, and watches that obtain some of their value from the prestige that individuals

get when others recognize that the individual is consuming exclusive goods.8In fact,

unlike typical products, the demand for conspicuous goods may rise with price.9

Not only are there different types of products, there are different types of advertising.

Classical treatments of advertising sometimes distinguish three types of advertising:

informative, persuasive, and complementary.

6. See David N. Laband, Advertising as Information: An Empirical Note, 68 REV. ECON. & STAT. 517

(1986).

7. Michael Porter, Consumer Behavior Retailer Power and Market Performance in Consumer Goods

Industries, 56 REV. ECON. & STAT. 419 (1974).

8. Wilfred Amaldoss & Sanjay Jain, Pricing of Conspicuous Goods: A Competitive Analysis of Social

Effects, 42 J. MARKETING RES. 32 (2005).

9. Id.


Informative advertising is advertising that firms undertake to communicate product

information to the consumer. This information enables the consumer to evaluate the

utility he will obtain from buying the product. A magazine advertisement might, for

example, show pictures of the product, describe its features, and inform upon how or

where to purchase it. To be fully informative, it must also indicate the price of the

product. Grocery or department store mailers that announce sales and special product

offers are prototypical examples of informative advertising.

The lack of hard information on a typical television commercial, however, suggests

that the advertising often does not involve the direct provision of detailed information

about a product. Classical treatments of advertising explain this observation by

suggesting that advertising also has a persuasive role. Specifically, advertisers use

advertising to communicate messages designed to raise the consumers willingness to

pay for their product. It is in this sense that advertising persuades a potential buyer that

there is greater benefit from the product than he previously believed.

A key difference between these two roles is that, with informative advertising, a

consumers knowledge of the product (existence, price, where to buy, etc.) is updated

upon seeing the advertisement, while the consumers fundamental preferences remain

unchanged. In contrast, a persuasive advertisement affects a consumers preference for

the product.

Complementary advertising involves the related notion that advertising provides an

image that complements the physical characteristics of the product.10For instance,

consider a television commercial that shows a famous basketball player wearing a

particular brand of footwear. Such an advertisement might give a teenager a chance to

enjoy an association with the famous player whenwearing the shoes. The teenager then

accrues an added benefit from this association beyond any inherent quality

characteristics of the shoe itself. The seller may accordingly charge a premium for the

product in order to capture this added value.

Closely related to complementary advertising is its ability to facilitate social

interactions within consumer segments. To illustrate, suppose a man smokes, and he

wants to smoke what other men smoke. Perhaps even more, he would rather not smoke

something that women smoke. If there are several brands of cigarettes and men do not

knowwhat their peers are smoking, then theywill make a guess among existing brands.

If, on the other hand, a cigarette brand Y designs and airs advertising that appeals only

to men, then men conclude that brand Y is for them. In addition, although women also

see this ad, women do not buy brand Y, and men know this. Hence all men coordinate

on the right brand. This coordination role of advertising was first noted by Chwe11

and, while it is a compelling explanation for the prominence of advertising for

conspicuously consumed products, it has not yet received a great deal of attention by

economists.

10. SeeGary S. Becker &KevinM.Murphy, A Simple Theory of Advertising as a Good or Bad, 108 Q. J.

ECON. 924 (1993).

11. Michael Chwe, Believe the Hype: Solving Coordination Problems with Television Advertising

(University of Chicago Department of Economics, Working Paper, 1998).


Given the different types of advertising and the different types of products, it is not

surprising that different products are associated with different levels and types of

advertising. For example, products that are pure search goods, such as homogeneous

products that are easily graded (such as crude oil), are observed to have much lower

levels of advertising than experience goods.12While it remains to be fully tested,

products for which the persons utility depends on others tastes may be subject to more

image advertising than experience goods or search goods for which there is repeat

purchasing and only the purchasers utility is at issue. However, these types of

generalities may not hold in particular circumstances because firms can convey

information and brand image to consumers using other forms of promotion, such as sales

support, product packaging, and trial sampling. Moreover, because consumers have

diverse preferences, different advertising and promotional strategies may be used to

target distinct types of consumers.

2.2. Advertising as a signal

While advertising may involve the straightforward provision of information that

underlies the notions of informative, persuasive, and complementary advertising, some

economists have explored the possibility that advertising may provide consumers with

valuable information beyond its explicit content by providing consumerswith a signal

about the quality of the product. According to this part of the economics literature, the

level of advertisingnot the content of the advertisingsignals consumers that a

particular product is of a particular quality. Specifically, when it is more beneficial for

high-quality sellers to advertise than low-quality sellers, firms that supply high-quality

products are expected to undertake more advertising and thus advertising intensity can

signal product quality. However, economists have come to recognize that the accuracy

of the signal depends on the market context.13The roles defined above are a useful

starting point to analyze the antitrust aspects of advertising. It is possible, however, to

extend these roles on more microeconomic foundations. In this section, I consider one

more view to give a broader perspective: the signaling role of advertising. Because the

remainder of the chapter does not rely on this section, it can be skipped without loss of

continuity.

The persuasive role of advertising assumes that consumer preferences are subject to

change and that affected consumers are unable to detect the persuasive intention of the

advertising firm. Such an assumption might be difficult to maintain if consumers are

rational. Any seller of an experience good, for instance, may claim that its product is

high quality, regardless of the true quality level. A rational consumer then should

consider all persuasive messages meaningless.

I offer an explanation of how persuasive advertising can credibly communicate a

products quality to a rational consumer. Nelson was the first to suggest the signaling

role of advertising.14To illustrate his argument, consider the case when sellers of an

12. DOUGLAS F. GREER, INDUSTRIALORGANIZATION AND PUBLIC POLICY 127-29 (1992).

13. JEAN TIROLE, THE THEORY OF INDUSTRIALORGANIZATION 116-26 (1994).

14. Phillip Nelson, Advertising as Information, 82 J. POL. ECON. 729 (1974). For formal extensions of

Nelsons idea, see PaulMilgrom& John Roberts, Price and Advertising Signals of Quality, 94 J. POL.


experience good cannot make credible claims about high quality; a low-quality seller

loses little by claiming its quality is high. A seller of high-quality experience goods can,

however, signal its quality by spending a sufficient amount on advertising. Suppose

consumers become repeat customers only if they enjoy high quality upon the first trial.

Due to repeat sales, the high-quality seller has more potential profit than a low-quality

imitator. In order to credibly convince the consumer it is high quality, the seller can

publicly spend off or burn some of these future profits by advertising to such an extent

that a low-quality producer would find it unprofitable to imitate. The rational consumer

observes this seller spending lots of money on advertising and concludes that it is

offering a high-quality product. It is worthwhile to note that the advertising message

itself is irrelevant beyond the cost to provide it. As long as consumers know howmuch

money was burned. Hence, a widely publicized charitable donation can also be a

credible signal in the same way as a costly advertising campaign.

The signaling theory offers an alternative to the persuasive advertising theory when

trying to explain why one observes certain types of persuasive advertising that contains

little direct information. To the extent high levels of advertising signal higher quality,

the mere act of advertising conveys reliable quality information to consumers and thus is

consistent with the observation that famous brands of cars, dish detergent, and other

goods with experience attributes are heavily advertised on television and contain little

hard information other than look how much money Im spending on advertising.

One still has difficulty using the signaling argument to explain all forms of

persuasive advertising. Productsfor example, popular brands of cola and beerhave

long been in existence, and it is likely that most people have experienced them at some

point or another. The signaling story, therefore, is an unlikely role for the ubiquitous

advertising for these popular brands given that most people have tasted them and

evaluated their true quality. As a result, the signaling role of advertising has been more

commonly attributed to new product launches.15

The quality signaling role of advertising has received some, but limited, empirical

support. The strongest support comes from experimental marketing studies.16Caves

and Greene, on the other hand, find few correlations between advertising outlays and

Consumer Reports ratings of quality.17

3. The firms advertising decision

Advertising is a business activity firms presumably choose to improve their profits

through its effect on consumer demand. Specifically, the information provided by

advertising may increase sales volume and permit price increases, both of which will

benefit firms in the form of increased revenues. However, advertising is a costly activity

ECON. 796 (1986); Richard Kihlstrom&Michael Riordan, Advertising as a Signal, 92 J. POL. ECON.

427 (1984); and Benjamin Klein & Keith B. Leffer, The Role of Market Forces in Assuring

Contractual Performance, 89 J. POL. ECON. 615 (1981).

15. SeeMilgrom & Roberts, supra note 14.

16. Amna Kirmani, The Effect of Perceived Advertising Costs on Brand Perceptions, 17 J. CONSUMER

RES. 160 (1990).

17. Richard Caves & David Greene, Brands Quality Levels, Prices and Advertising Outlays: Empirical

Evidence on Signals and Information Costs, 14 INTL J. INDUS. ORG. 29 (1996).


and, as a result, choosing the optimal amount of advertising requires balancing its costs

and benefits. Economists have developed a useful framework for assessing the trade-off

between advertisings costs and benefits. I explore this framework below in a classical

model set forth by Dorfman and Steiner.18

The model allows us to focus on the firms incentive to advertise with respect to

demand conditions and its pricing decision. The firm faces a demand function,

( , )q D p A! , which reflects the quantity demanded as function of price, p , and its

spending A on advertising. I assume 2 2/ 0 /D p D p" " # # " " to reflect a downward

sloping (and convex) demand curve and 2 2/ 0 /D A D A" " $ $ " " to reflect the notion that

advertising increases demand for the product at a decreasing rate. Note that our

reduced-form specification of demand permits us to be agnostic with respect to the

views of advertising discussed above. What is important is that advertising simply

affects market demand, and I do not account for its specific impact on consumer

information or preferences.

The firm chooses p and A in order to maximize its profits:

( , ) ( ) ( , )p A p c D p A A% ! & & (1)

where 0c $ denotes the marginal cost of the product. Under our assumptions, the

following two first-order conditions define the optimal decision of the firm:

( , ) ( , )( , ) ( ) 0

p A D p AD p A p c

p p

%" "! ' & !

" "(2)

( , ) ( , )( ) 1 0

p A D p Ap c

A A

%" "! & & !

" "(3)

These equations depict the optimizing condition of equating marginal revenue to

marginal cost with respect to price and advertising, respectively. By manipulating the

equations, I can interpret them differently. For example, define the price elasticity of

demand as ( / )( / )p p q D p( ) " " , multiply Equation (2) by pq( , and rearrange to get

1

p

p c

p (

& &! (4)

This states that the optimal relative price margin, or percent contribution margin, is

inversely related to the value of price elasticity. Consistent with intuition, inelastic price

elasticity leads the firm to set high margins.

Now consider the advertising choice. First note that we can define the advertising

elasticity of demand as ( / )( / )A

A q D A( ) " " , which states the percent increase in sales

for a 1 percent increase in advertising. Multiply Equation (3) by /Aq p( , substitute in

Equation (4), and rearrange to get

18. Robert Dorfman & Peter O. Steiner, Optimal Advertising and Optimal Quality, 44 AM. ECON. REV.

826 (1952).


A

p

A

pq

(

(!&

(5)

Expressed this way, Equation (5), known as the Dorfman-Steiner equation, has a

convenient interpretation. At the optimum p andA, the advertising to sales ratio is equal

to the ratio of advertising elasticity to price elasticity. This suggests that the firm will

advertise more whenever demand is very responsive to advertising (i.e., highA

( ). This

helps to explain, for example, why there is interest from brand advertisers to advertise to

children and young adults, whose preferences are highly malleable and influenced by

advertising. Conditions in the commercial media industry (e.g., television or radio) can

conceivably affect this advertising effectiveness as well.19

Equation (5) further holds that the firm will advertise more if demand is relatively

price-insensitive (low | |p( ). Intuitively, a firm facing a less elastic demand obtains

higher margins from each additional consumer. This gives the firm a bigger incentive to

use advertising to generate new customers. Given that automobiles had contributions

margins over 15 to 20 percent in the latter part of the twentieth century,20Equation (5)

appears consistent with the observation that the Big 3 domestic automakers were

among the top ten advertisers in the United States during that time.21

Note that I have not discussed how advertising may affect price elasticity p( . We

can relate advertisings effect on price elasticity to the two views on advertising, as

discussed in Section 2. If, under an informative role, advertising generates additional

consumers or makes them more aware of market prices, it would lead to higher

elasticities. Alternatively, under the persuasive view, consumers become more

committed to a particular brand, and as a result elasticity is lower.

Finally, note that factors affecting elasticities on the right-hand side of Equation (5)

affect optimal advertising and price jointly. For example, the state of the commercial

media industry, television or radio, could conceivably alter a firms ability to

communicate with the market and thereby elasticity of advertising A( , therebyaffecting

the optimal choice. To illustrate, suppose that a new health study reveals enormous

benefits for ingredients found in some breads. If this has a decreasing effect on the price

elasticity for certain breads, then Equation (4) predicts an increase in the margin for

bread and Equation (5) predicts increases in advertising as well. Makers of the healthful

bread, seeing higher marginal benefits from sales, use advertising to generate them.

The central lesson from this analysis is that a firms advertising decision involves a

trade-off and, more importantly, this trade-off can very well depend on other factors

under the firms control, most notably price. This fact has important empirical

implications, especially when looking to the data for causal relationships between

advertising and price. This issue arises in Sections 4.3 and 4.4.

19. See Anthony Dukes, Media Concentration and Consumer Product Prices, 44 ECON. INQUIRY 128

(2006).

20. See F.M. SCHERER, INDUSTRY, STRUCTURE, STRATEGY, AND PUBLIC POLICY ch. 8 (1996); Steven

Berry, James Levinsohn&Ariel Pakes, Automobile Prices inMarket Equilibrium, 60 ECONOMETRICA

889 (1995).

21. 100 Leading National Advertisers, ADVERTISINGAGE, June 25, 2007.


The preceding model involves a number of simplifying assumptions that affect the

results. For example, it assumes away any strategic interactions among two or more

advertising firms. I address this specifically in the next section. The preceding analysis

also ignored the possibility that advertising may have lagged effects, whichwould affect

the calculation of the revenue effects.22For example, the incentive tomorrow depends

on the durability of yesterdays advertising. This issue has implications for antitrust

when evaluating the extent to which there is long-run advertising capital that serves as

a barrier to entry. This issue is discussed later in Section 4.4.

4. Advertising and competition

The Dorfman-Steiner analysis of advertising behavior is not well-suited for

providing insights into the strategic interplay between competing firms. As such, the

model does not show how firms vary their advertising and prices in response to changes

in other firms advertising. I now turn to a discussion of strategic interactions between

firms. One model considers the interaction of firms advertising strategies and why

firms might want to achieve a consensus to reduce advertising. A secondmodel focuses

on using advertising to differentiate a firms product so that rivals products are viewed

as more distant substitutes.

4.1. Interaction of competitive advertising strategies

In the previous analysis, it is appropriate to think of advertising as a way that a firm

can increase market demand. However, when a firm faces competition from existing

rivals or potential entrants, it will recognize that advertising may not only increase

general market demand but also increase the demand for the advertisers product at the

expense of its competitors. I will consider two models that recognize both the ability to

divert customers from rivals and the fact that firms will realize that rivals will react to

changes in advertising strategy.

To illustrate the economic incentives that are related to advertising that diverts sales

from competitors, I start with a simple game played by two firms. Assume that these

firms face a total market of 1,000 consumers. Either firm can choose one of two

strategies: to advertise or not to advertise. Without advertising, firms split the market

and each obtain 500 customers. If firms face marginal cost of $1 and their optimal price

is 2$!p , then they each earn profits of $500, less fixed costs, which we can ignore.

Now suppose that a firm can invest $100 in advertising to obtain 250 additional

customers. If one firm advertises and the other does not, then the advertising firm earns

revenue of $750 ($1 750* ) less advertising cost for a profit of $650. The

nonadvertising firm is left with 250 customers and a profit of $250. If, however, the

other firm also decides to advertise, then it gets 250 additional customers, neutralizing

the original loss of 250, and the market is again equally split. In this case, both firms

earn $500 less advertising costs, for a total of $400. Using these calculations, this

advertising game can be represented by the matrix in Figure 1. Note that each firmhas a

22. Marc Nerlove & Kenneth Arrow, Optimal Advertising Policy under Dynamic Considerations, 29

ECONOMICA 129 (1962).


strategic incentive to advertise. No matter what Firm 2 does, it is best for Firm 1 to

advertise; similarly for Firm 2. This leads to an equilibrium in which both firms

advertise. The unfortunate consequence for both firms is that they are worse off than if

they both did not advertise. Thus, the ability to advertise can create a prisoners

dilemma in industries where advertising is effective for business stealing.

Note that I assumed that prices stay constant before and after advertising. The

prisoners dilemma becomes even more pronounced if advertising leads to lower prices.

One might anticipate this situation whenever consumers view products as relatively

undifferentiated but have imperfect information about competing prices. If search costs

are nontrivial, uninformed consumers may stop at the first seller they find. Knowing

this, the seller can then charge higher than competitive prices. Without advertising,

therefore, each participating firm can enjoy a set of loyalhigh-payingcustomers. If

price advertising is possible, however, a firm could easily acquire a big jump in revenue

by targeting a rivals loyal customers and advertising a slightly lower price. If all firms

adopted this strategy, one would expect prices and profits to fall. That is, the payoffs in

the equilibrium outcome (Advertise, Advertise) would be even lower than $400.

The discussion above points to a potential benefit to firms if they could somehow

commit themselves to not advertise. One way that firms might try to reduce competitive

advertising is to use a common marketing agency to control the level of advertising.

Another way is to induce regulated limits on advertising as has been done for

professional services such as lawyers and doctors. Another possibility, which occurs in

markets where advertising strategy in one period may depend on what happened in

earlier periods (which are modeled as repeated games), is to undertake disciplinary

advertising levels whenever rivals cheat by doing more advertising than was agreed

(possibly implicitly) upon.

4.2. Use of advertising to differentiate products

Competitive incentives to advertise need not always lead to business stealing

problems for firms. In some cases, advertising can serve to differentiate products so that

consumers view the products as more distant competitors, reducing the cross-elasticity

of demand between the products. Such a situation may arise under the complementary

role of advertising discussed above. Recall that under this role, it is advertising images

that are sold along with the product. As a result, competing firms can choose images

that appeal to segments of the market to insulate their product to some extent from the


pricing of potentially substitutable products, perhaps even creating a separate relevant

product market.23

To illustrate the economic incentives to undertake this type of strategy, consider the

following advertising game played by two firms: Both firms sell colas that are otherwise

similar in taste. A set of 1,000 consumers are fully familiar with the two brands. If the

firms do not advertise, they split the market at the competitive price of $2. Given a

marginal cost of $1, each firm obtains $500 profit. Suppose that consumers can be

divided into two groups: young and old. Further suppose that Firm 1 can appeal to

young people through its advertising images at a cost of $100. If this segment becomes

more loyal, Firm 1 can raise its price from $2 to $3, giving profit of $900

($(3 1) 500 100& * & ). What is the consequence to Firm 2? Given that Firm1 has raised

its price, the residual demand facing Firm 2 is less elastic. Firm 2 can then raise its price

to $2.50 even though it does not advertise. Its profit in this case is $750

($(2.5 1) 500& * ). Now suppose that Firm 2 decides to advertise. Then the price effect

is doubled because of its effect on Firm 1s demand. Consequently, when both firms

advertise, prices go up to $4, leading to profits of $1,400. Clearly, the outcome with

both firms advertising is the equilibrium of this game (summarized in Figure 2) and, in

contrast to the previous situation, makes firms better off than with no advertising.

The preceding discussion illustrates theoretically howpersuasive advertising can be a

means to relax price competition. Section 4.1, in contrast, illustrated the opposite

outcome for informative advertisingnamely, that advertising could facilitate lower

prices. While these results point in opposite directions with respect to competitive

outcomes, it is important to bear in mind that they are not contradictory. Rather, they

illustrate the need for caution when applying a uniform role for advertising for the

purposes of assessing its impact on competition.24

4.3. Advertising and competitive outcomes: empirical findings

Based on our theoretical discussions above, some questions emerge. First, does there

exist a causal relationship between advertising and competitive market outcomes? In

23. The antitrust authorities sometimes recognize narrow product markets that are based on product

differentiation. For example, the antitrust agencies have found a separate superpremium ice cream

market. See Complaint at IV, Nestle Holdings, Inc., FTC Dkt. No. c-4082 (June 25, 2003).

24. For accessible and illustrative examples of how and when differentiation is facilitated by advertising,

see David A. Soberman, The Role of Differentiation in Markets Driven by Advertising, 45 CAL.

MGMT. REV. 130 (2003).


answering this question, economists have focused on the relationship between

advertising and prices. Specifically, this research attempts to determine whether firms

ability to advertise causes higher or lower prices. In this section, I examine the current

state of empirical research on advertising and prices. Unfortunately, it does not take us

far. The problem is either that much of the data is too specialized or that the studies

suffer from methodological difficulties inherent in advertising research. That is not to

say one has nothing to learn from the body of empirical findings. However, one should

avoid overgeneralizing their results.

Though early studies have found a positive link between advertising and product

prices,25one cannot be certain that advertising caused higher prices. Recall from our

analysis in Section 3 that high margins induce the firm to advertise more since its

benefits are greater than with lowmargins. This means that the reverse or neutral case is

also plausible. That is, we cannot rule out the possibility that high prices cause more

advertising, or that some common underlying demand process is driving both high

prices and high advertising.

Therefore, at best, we can offer the following empirical test: if advertising facilitates

competition, then it should cause prices to fall. However, establishing causality is not

simple and cannot be done adequately from a simple cross-section of industry prices and

advertising spending. Some studies have circumvented this causality problem by

exploiting natural experiments by which some external process (such as a legal

restriction) prevented advertising in some geographical region or during some period in

time. Benham, for example, showed that the price of eyeglasses was higher in states

where optometrists were forbidden to engage in price advertising.26Similarly, Glazer

examined prices of several grocery items before, during, and after the 1978 newspaper

strike in New York City.27He found that prices were higher during the strike when

stores could not communicate prices to consumers through newspaper ads. And, more

recently, Milyo and Waldfogel examined the impact of the removal of a Rhode Island

ban on liquor stores that advertised the price of alcoholic beverages.28They found that

prices fell after the ban was removed by the Supreme Court in 1996.

These studies support the view that price advertising leads to more competitive

outcomes. Because price advertising informs consumers of available prices, sellersmust

compete more aggressively on price. One must bear in mind, however, that these

studies had a specific feature in common: they all involved price advertising among

retailers who carried similar product assortments. This is a consistent fit with the

informative role discussed in Section 2 and one should avoid generalizing this regularity

to other forms of nonprice advertising.

For the case of nonprice advertising, there is some experimental evidence that it

reduces consumers price sensitivity and, thus, may lead to higher prices. For example,

25. See F.M. SCHERER&D. ROSS, INDUSTRIALMARKET STRUCTURE AND ECONOMIC PERFORMANCE

(1990); Lester Telser, Advertising and Competition, 72 J. POL. ECON. 573 (1964).

26. Lee Benham, The Effect of Advertising on the Price of Eyeglasses, 15 J.L. & ECON. 337 (1972).

27. Amihai Glazer, Advertising, Information, and PricesA Case Study, 19 ECON. INQUIRY 661 (1981).

28. JeremyMilyo & Joel Waldfolgel, The Effect of Price Advertising on Prices: Evidence in the Wake of

44 Liquormart, 89 AM. ECON. REV. 1081 (1999).


Krishnamurthi and Raj studied a split-cable television experiment in which consumer

panels were shown differing amounts of advertising.29The main finding was that

nonprice advertising for a well-established brand decreased consumers price sensitivity.

Under the persuasive role, this sort of advertising helps the firm position its product by

differentiating it vis--vis competing brands. A behavioral interpretation is that the

advertisements nonprice content distracts consumer attention away fromprice.30Given

this result, it is important to bear in mind that even if nonprice advertising leads to

higher prices, it does not automatically imply a reduction in consumer welfare. In

particular, nonprice content may, in fact, enhance the consumers value of the product

under the complementary view of advertising.

In addition to the controlled experimental studies, there is one additional studyworth

noting from the cigarette industry. Cigarette advertising on television, arguably

considered as nonprice advertising, was banned in the United States in 1970. Eckard

used this ban as a natural experiment on the competitive aspect of nonprice

advertising.31In contrast to the above experimental studies, his analysis found that the

price-cost margins of major cigarette firms were higher after the television commercial

ban.

In sum, the empirical results on advertising and competition are tenuous.

Nevertheless, there is evidence suggesting that the ability of firms to use informative

price advertising leads to more competitive outcomes. There is also evidence that

noninformative advertising may lower consumers price sensitivity, but its general effect

on competition is ambiguous.

4.4. Advertising, concentration, and barriers to entry

Economists have long theorized about the possibility that advertising by incumbent

firms may create barriers to entry by potential rivals. One theory suggests that

advertising is a means to communicate or signal its ability to drive out potential

competitors should they enter.32Another theory states that if advertising has long-run

persuasive effects on consumers, then an incumbent can invest in advertising in order to

tighten its grip on consumers, thereby imposing additional costs on any potential

entrant.33The notion that advertising is an investment and may have a long-term effect

on consumers is referred to as goodwill capital. The latter theory has received the

most attention by economists, especially with respect to finding empirical evidence

29. Laksman Krishanmurthi & S.P. Raj, The Effect of Advertising on Consumer Price Sensitivity, 22 J.

MARKETING RES. 119 (1985).

30. Anil Kaul &Dick R.Wittink, Empirical Generalizations about the Impact of Advertising onSensitivity

and Price, 14 MARKETING SCI. 151 (1995).

31. E. Woodrow Eckard, Jr., Competition and the Cigarette TV Advertising Ban, 29 ECON. INQUIRY 119

(1991).

32. Kyle Bagwell & Gerry Ramey, Advertising and Pricing to Deter or Accommodate Entry When

Demand is Unknown, 8 INTL J. INDUS. ORG. 93 (1990).

33. Richard Schmalensee, Product Differentiation Advantages of Pioneering Brands, 72AM. ECON.REV.

349 (1982); Avinash Dixit & Victor Norman, Advertising and Welfare, 9 BELL J. ECON. 1 (1978).


supporting or refuting the use of advertising as a means to erect entry barriers.34In this

section, I review these empirical findings.

Many studies begin with the hypothesis that if advertising is a barrier to entry, then

one should observe in industries with heavy advertising either (1) higher firm

concentration, or (2) higher economic profits relative to industries with less advertising.

Using cross-sectional interindustry data, early studies found little, if any, linear

association between industry concentration measures and advertising intensity.35Later

studies, however, recognized that cross-sectional data might not reveal advertisings

goodwill effects which are built over time. Using 30 years of time-series data, Mueller

and Rogers observed an increase in the concentration measures in consumer goods

industries over the growth era of television advertising, i.e., from1947 to 1977.36While

this effect was not present for industrial goods, they found that television advertising

could explain a large portion of the change for consumer goods. It is not conclusive,

however, whether television advertising caused increases in market power over this

time.

The 1970 ban on the television advertising of cigarettes in the United States,

however, offered a natural experiment to test the hypothesis that advertising strengthens

market power, as measured by firm concentration. Evidence from several studies of this

event contradict this hypothesis.37In fact, Eckards analysis of cigarette industry data

before and after the ban suggests that the elimination of television advertising increased

industry concentration levels, which had been declining before the ban.38This analysis,

as well as that by Holak and Reddy, further indicates that the 1970 advertising ban

reduced brand switching.39

All of this work suggests that there is little evidence of a linear and positive

association between advertising and industry concentration. A good bit of work has

been devoted to the possibility of a more complex, nonlinear association. Sutton, for

example, suggest an inverted U-shaped relationship in which advertising intensities are

positively associated with low degrees of concentration up to a point, after which there

is a negative association.40One possible reason attributed to a drop-off in advertising in

highly concentrated industries is based on the business stealing notion of competitive

advertising. If there are fewer firms, then it is easier for them to cooperate in a less

34. JOE BAIN, BARRIERS TO NEW COMPETITION: THE CHARACTER AND CONSEQUENCES IN

MANUFACTURING INDUSTRIES (1956).

35. See, most notably, WILLIAM COMANOR & THOMAS WILSON, ADVERTISING AND MARKET

STRUCTURE (1974); and Nicholas Kaldor, The Economic Aspects of Advertising, 18REV. ECON. STUD.

1 (1950).

36. Willard F. Mueller & Richard T. Rogers, The Role of Advertising in Changing Concentration of

Manufacturing Industries, 62 REV. ECON. & STAT. 89 (1980).

37. See Eckard, supra note 31; Mark Mitchell & J. Harold Mulherin, Finessing the Political System: The

Cigarette Advertising Ban, 54 S. ECON. J. 855 (1988).

38. See Eckard, supra note 31.

39. Id.; Susan Holak & Srinivas Reddy, Effects of a Television and Radio Advertising Ban: A Study of the

Cigarette Industry, 50 J. MARKETING 219 (1986).

40. See JOHN SUTTON, SUNK COSTS AND MARKET STRUCTURE (1991); John Sutton, Advertising,

Concentration, and Competition, 84 ECON. J. 56 (1974).


competitive advertising environment.41The overall body of evidence of the invertedU-

shaped relationship is mixed, however.42

What about the relationship between advertising and industry profit levels? Some

empirical support for this may be found in the industry cross-sectional analysis of

Comanor and Wilson,43which finds a significant and positive correlation between

accounting profit rates and advertising to sales ratios. One important challenge to this

analysis is whether the reported accounting profit rate is an unbiasedmeasure of the true

profit rate. In particular, it has been shown that the accounting profit rate may overstate

the true profit rate when advertising expenditures are inappropriately depreciated as

capital investments.44As noted by Weiss, one may consider advertising spending as

long-term investments in goodwill, an intangible notion of capital that exists in the

form of long-term brand loyalty.45Ayanian takes this notion further and suggests that

the rate at which goodwill capital decays, or depreciates, has dire implications for the

relationship between incumbent profitability and advertising intensities.46

Using

advertising and accounting profit data from 39 firms over ten years, he estimates the

depreciation rate of advertising and reevaluates the relationship between firms

accounting profits and advertising. His analysis indicates thatwhen one accounts for the

decay of advertising goodwill, the positive association between profits and advertising

intensity disappears.

The analysis of Ayanian has, itself, been challenged and economists remain unsure

as to the true degree of bias in profit measures.47But even if one acceptsComanors and

Wilsons measure of profits,48their cross-sectional data does not foreclose the

possibility that profits and advertising are driven by the same, unobserved, process.

As with advertising and concentration, the 1970 ban on cigarette advertising offered

a natural experiment to assess causality of advertising and profits. The regressions of

Mitchell and Mulerin indicate a significant increase in the stock prices of cigarette

industry firms at the time of the ad ban.49They suggest that this increase reflects

investors beliefs of future profitability of the cigarette firms due to reduced

competition.

In general, the body of empirical research offers little convincing evidence

supporting the hypothesis that firms advertising intensity is positively related to

industry concentration ratios or profits. The implication is that there seems to be little

indirect evidence that there are barriers to entry in heavily advertised industries. Direct

41. See Douglas F. Greer, Advertising and Market Concentration, 38 S. ECON. J. 19 (1971).

42. See Bagwell, supra note 3.

43. See COMANOR & WILSON, supra note 35; William Comanor & Thomas Wilson, The Effect of

Advertising on Competition: A Survey, 17 J. ECON. LITERATURE 453 (1979).

44. Harold Demsetz, Accounting for Advertising as a Barrier to Entry, 52 J. BUS. 345 (1979).

45. Leonard Weiss, Advertising, Profits, and Corporate Taxes, 51 REV. ECON. & STAT. 421 (1994).

46. Robert Ayanian, Advertising and the Rate of Return, 18 J.L. & ECON. 479 (1975).

47. The nature of the debate revolves around estimating the depreciation rate of advertising goodwill,

which depends directly on the duration of advertisings long-run effects on consumers. Clarks review

of the empirical research suggests a duration interval of three to 15months. Darral Clark,Econometric

Measurement of the Duration of Advertising Effect on Sales, 13 J. MARKETING RES. 345 (1976).

48. See COMANOR&WILSON, supra note 35.

49. SeeMitchell & Mulherin, supra note 37.


evidence, however, might be found by examining actual entry decisions by generic drug

manufacturers in the pharmaceutical industry. Scott-Morton examined 98 drugs that lost

patent protection between 1986 and 1992 and estimated the factors that affected entry by

generics.50She finds, in fact, that advertising may affect entry (either positively or

negatively) when advertising is treated exogenously. However, the problem with the

exogeneity assumption, she notes, is that if a market is sizable enough to enter, it is also

worth advertising in. By treating advertising as endogenous for the incumbent, she finds

the effects of advertising are insignificant for entry decisions. She concludes that brand

advertising is not a barrier to entry in the United States pharmaceutical market.51

While the empirical evidence from industry data does not support the notion that

advertising is a barrier to entry, some survey and managerial research supports it. For

example, according to surveys, product managers view advertising as a strategic tool to

prevent competitive entry.52In addition, there are reports of incumbent brands using

advertising copy intended to interfere with the advertisements of an entrant. Hilke and

Nelson document a federal antitrust case in which the producers of Maxwell House

brand coffee were accused of mimicking the advertising copy of new commercials by

the entering brand, Folgers.53Behavioral studies in marketing offer support for the

notion that the incumbent brand has the advantage over the entrant of being first in the

consumers memory when faced with similar but competing advertisements.54

In conclusion, there is a good bit of evidence that advertising is viewed as a possible

means for an incumbent firm to thwart entry. However, evidence from actual industry

choice data that advertising actually prevents entry is slim.

5. Advertising and economic welfare

Economists have also explored whether there is too much or too little advertising

from the point of view of social welfare. At the simplest level, firms may have an

incentive to invest in advertising to differentiate their product so that their pricing is

insulated from rival prices. This private incentive may not align with the social value of

the advertising, and, as a result, there may be too much advertising. On the other hand,

firms that advertise may provide socially valuable information that expands the overall

size of the product market, which will benefit rivals as well as themselves. Because an

advertiser may not capture all of the benefits of its advertising, advertisers maynot have

sufficient incentive to undertake as much advertising as is socially desirable. Given

these (or similar) conflicting economic forces, economists have struggled to determine

whether there is too much or too little advertising.

50. Fiona M. Scott-Morton, Barriers to Entry, Brand Advertising, and Generic Entry in the U.S.

Pharmaceutical Industry, 18 INTL J. INDUS. ORG. 1085 (2000).

51. Id. at 1103.

52. See David Bunch & Robert Smiley, Who Deters Entry? Evidence on the Use of Strategic Entry

Deterrents, 74 REV. ECON. & STAT. 509 (1992).

53. John C. Hilke & Philip B. Nelson, Noisy Advertising and the Predation Rule in Antitrust Analysis, 74

AM. ECON. REV. 367 (1984).

54. See Anand Kumar & Shanker Krishnan, Memory Interference in Advertising: A Replication and

Extension, 33 J. CONSUMER RES. 602 (2004); Raymond R. Burke & Thomas K. Skrull, Competitive

Interference and Consumer Memory for Advertising, 15 J. CONSUMER RES. 55 (1988).


To better understand this debate, it is helpful to consider the welfare effects of

advertising in the simple monopoly advertising model discussed above in Section 3. To

start, we evaluate the case in which advertising is persuasive and leads to a market price

increase.55Let 0 0( , )D p A denote the demand curve at an initial level of advertising. As

before, the marginal cost of production is constant at 0c $ . Denote by 0p the

monopolists optimal price, which leads to output 0 0 0 0( , )q D p A! , as depicted in

Figure 3. Initial welfare is the sum of consumer and producer surplus, which is the area

below the curve 0D and above the marginal cost line from 0 to 0q .

I now consider the change in welfare after a marginal increase in advertising to

1 0A A A! ' + . This increase in advertising shifts demand to 1 1( , )D p A . Recall that we

are assuming the monopolists optimal price increases due to advertising: 1 0p p$ .

Referring to Figure 3, we graphically assess the distribution of welfare change. The

total change in welfare W+ due to the advertising increase is the area abde less the

additional cost of advertising A+ . This is the additional surpluses (producer plus

consumer) from the added consumption facilitated by the advertising. This welfare

55. This analysis was originally contributed by Avinash Dixit and Victor Norman. See Dixit & Norman,

supra note 33.


change, gross A+ , can be dissected in two parts, areas gbde and abg, where the latter is

only of second-order importance (on the same order as p q+ + ). This can be neglected

for marginal changes in A (i.e., small A+ ).

Also note that the additional profit to the monopolist, %+ , is the area obdefpp1 less

the additional cost of advertising A+ . This, and the above discussion, allows us to

(first-order) approximate the change in welfare as

0W q p%+ , + & + (6)

Since an optimizing monopolist will set the marginal benefit of advertising equal to

its marginal cost, we have that 0%+ ! , leaving 0W+ # since 0p+ $ by assumption.

Note that the monopolists and the social planners incentives are aligned with

respect to costs, namely, A+ . However, for the monopolist, the private benefit of

additional monopoly power exceeds the public benefit of additional consumption.

Hence, the monopolist chooses socially excessive persuasive advertising.

It can be shown that this result does not depend on the monopoly market structure

assumed here.56In particular, as long as the firm has some degree of market power (i.e.,

under imperfect competition) it will employ socially excessive levels of persuasive

advertising.

It is possible, however, to challenge this result on the assumed role of advertising.

Recall that we measured welfare excluding the area between the demand curves

northwest of af (denoted Z) because these consumers would already have bought before

advertising. Measuring welfare in this way is appropriate only if the consumers

represented by the demand curve 1D were in the market prior to advertising and thus

were previously represented by 0D . If, however, we take a complementary role of

advertising by supposing that consumers enjoy the brand associations that complement

the actual product, then presumably all inframarginal consumers obtain added benefit

from advertising. Therefore, welfare calculations in Equation (6) should include the

area represented by area Z if advertising takes on a complementary role. This distinction

of advertisings role is crucial and challenges the result that advertising is socially

excessive. In particular, the size of area Z, depending on whether it is large or small

relative to 0q p+ , will determine whether W+ is positive or negative. But determining

this area requires us to make strong assumptions about the upper tail of the demand. As

such, it is difficult to make decisive conclusions about the nature of market failure in the

case of complementary advertising.

The informative role poses another challenge to the excessive advertising result. To

see this, suppose that advertising increases demand by informing a set of consumerswho

would otherwise not be aware of the products existence. Then our measurement of the

welfare effects must consider the added distributional benefits of advertising.57

To illustrate, reconsider the monopoly situation above and suppose that at state 0 a

set of n consumers are informed whose buying behavior is characterized by the demand

given 0 0( , )D p A . Further suppose that, by increasing advertising by 0A+ $ , an

56. See Dixit & Norman, supra note 33.

57. This was first pointed out by Shapiro. SeeCarl Shapiro, Advertising andWelfare: Comment, 12BELL

J. ECON. 749 (1980).


additional set of people become informed. To make matters simple, suppose that these

newly informed consumers are identical to the original group of n consumers. Then, the

new demand is twice the original. That is, 1 0 0 0( , ) 2 ( , )D p A A D p A' + ! , which

corresponds to a demand shift as illustrated in Figure 4. Since price elasticity of demand

remains constant under this assumed shift, we know from our analysis in Section 3 that

the monopolists optimal price remains at 0p .

The welfare accounting from the previous case applies as before, except that nowwe

include the surplus accruing those new consumers who would not have otherwise

consumed before the advertising, which is measured by the area abd. Including this

surplus, our welfare expression from Equation (6) gives

0W q p abd%+ , + & + ' (7)

As before, if the monopolist is profit maximizing with respect to advertising, then

%+ is zero. Therefore, since price is constant ( 0p+ ! ), the second term is also zero.

Hence, the change in welfare is positive: 0W abd+ , $ .

This implies that the monopolist advertises too little relative to the social optimum.

The additional benefit accruing to the newly informed consumers is not fully

appropriated by the advertising firm. The monopolists optimal advertising level,


therefore, is at a point where the marginal social benefit exceeds the marginal social

costs.

The reader might suspect that the simplifying assumption that 0p+ ! restricts

generalizations of this result. But this is not the case. Even if the price were to increase

from advertising ( 0p+ $ ), it is still possible for the net welfare change to be positive if

the surplus to newly informed consumers, as measured by area abd, is sufficiently high

relative to 0q p+ . If the optimal monopoly price falls after advertising, thereby

alleviating monopoly pricing distortions, then the marginal welfare gain is even greater

than area abd. Consequently, we have now a fairly general result: the monopolist

provides a socially insufficient level of informative advertising.

This market distortion occurs because the monopolist does not appropriate all the

additional social benefits accruing from informing new consumers. This would not be

the case, however, if the monopolist could price discriminate. For example, suppose the

monopolist had the ability to target its advertising messages. The monopolist, in

principle, could state different prices depending onwho receives the advertisement. By

charging prices closer to consumers valuations, the monopolist internalizes more

benefits of advertising. Practical difficulties aside, as the monopolists ability to price

discriminate becomes more perfect, the above analysis implies that the optimally chosen

level of advertising would approach the socially optimal level.

In summary, the above analysis suggests that when advertising is purely persuasive,

it tends to be socially excessive. On the other hand, the market level of informative

advertising tends to fall short of the socially optimal level. Finally, ambiguity arises

when determining the nature of market failure whenever advertising is viewed as

complementary.

The insights from our monopoly analysis can be extended to competitive settings by

noting that, in general, strategic incentives will tend to increase market levels of

advertising. For example, competition with informative advertising adds the business

stealing motivation for advertising.58Hence, compared to competitive situations, the

conclusions drawn from the monopoly analysis will tend to understate market level of

advertising relative to the socially optimal level.

Finally, it is important to point out that our analysis entirely neglected any social cost

associated with bothersome or obtrusive advertising. An advertisement, even if

informative, can impose a cost on the consumer not wishing to receive it. Unwelcome

spam and commercial interruptions during ones favorite television program are

examples of imposed nuisance costs on the recipient. And, because this cost is generally

not borne by the advertiser, market distortions arise.

6. Conclusion

This chapter serves as an introduction to the economic analysis of advertising and

competition. The intention is to provide an economic framework for evaluating the role

58. Grossman and Shapiro show that informative advertising in a competitive setting can be socially

excessive when the social cost of informing a consumer of an alternative product exceeds the

consumers gain of obtaining a lower price. See Gene Grossman & Carl Shapiro, Informative

Advertising with Differentiated Products, 51 REV. ECON. STUD. 63 (1984).


of advertising with respect to market outcomes as well as for assessing the degree to

which social and firm incentives are aligned. The reader should keep in mind that the

analysis in this chapter leaves a lot of questions unanswered. While economic research

on advertising continues, the summary below gives the main conclusions fromwhat has

been learned to date.

Economists have recognized that advertising is a complex process and that

attributing a one-size-fits-all approach can be misleading when assessing the

implications of advertising on competitive outcomes. For that reason, Section 2

described various roles advertising might take and the industry conditions or product

types for which each role is most appropriate. We also stressed that the typology of

advertising roles described here, while useful, is not exhaustive. Nor are the roles

exclusive; any given advertisement should not be seen as necessarily fulfilling exactly

one role.

Regardless of its role(s), we presume that advertising has positive effects on demand.

The amount of benefit to a firm, however, depends on how much it advertises, not to

mention a variety of consumer factors and the state of competition. Therefore, when

choosing an amount of advertising, the firm must balance this benefit with the cost of

advertising. Section 3 provided a framework that accounts for this economic trade-off.

An important, but simple, lesson from that analysis of this trade-off is that demand

factors, such as elasticity, may drive a firms choice of advertising levels and prices

simultaneously. This issue, as discussed in Section 4, has implications for assessing a

causal relationship between advertising intensity and price levels.

Section 4 illustrated how the role of advertising has profound, but opposing,

implications for how aggressively firms compete on prices. If advertisings role is

clearinformative or persuasivethen its theoretical impact on price competition is

also clear. However, as concluded fromSection 2, advertisings rolemaynot be so clear

in practice. Therefore, I turned to the body of empirical research for somemore specific

answers. Some important conclusions emerged:

the ability of firms to use price advertising tends to lower product prices;

there exists limited evidence that nonprice advertising lowers price elasticity;

and

stronger conclusions from empirical studies are severely weakened by data

limitations.

Section 4 also explored the hypothesis that advertising creates barriers to competitive

entry, industry concentration, and above normal industry profits. The bodyof empirical

research offered the following broad conclusions:

there is little evidence that advertising causes firm concentration or that the

ability to advertise ensures above normal industry profits;

the empirical economic evidence that advertising creates barriers to entry is

weak;

behavioral evidence suggests that an incumbents brand is recalled from

memory more often than an entrants when advertising messages are similar;

and


business managers report in surveys that they view advertising as a potential

entry deterrent.

Finally, Section 5 analyzed the extent to which competitive market incentives align

with social incentives. The theory predicted purely persuasive advertising tends to be in

excess of the social optimum. However, this result becomes ambiguous under the

complementary role of advertising. Finally, informative advertising levels may fall

short of the social optimum. There is virtually no empirical research to help resolve

much of this theoretical ambiguity.

Vol IChap 22CompetitionLaw_m1

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