Lecture Seven

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The Nature and Roles of Advertising
 The term ‘‘advertising’’ is expenditure undertaken
by a firm to promote the sales of its products or
services.
 The most visible form of advertising is paid-for space
in print, radio or television media.
 Advertising also includes promotional activity for a
product, such as special displays, offers in shops or
at commercial shows.
 Economists distinguish two roles of advertising.
 The first: is the provision of factual information to
consumers about the characteristics of a product, its
price and its availability.
 Such advertising helps consumers overcome information
deficiencies.
 The second: is the persuasion of consumers to buy a
particular product or visit a particular shop or
restaurant, by emphasizing the qualities of the product or
associating the product with a particular life style or
celebrity.
 Such advertising is sometimes comparative in nature,
with one producer comparing its product with those of
others, with the intention of making the advertised firm’s
product look superior.
 The implicit assumption: is that informative
advertising is good for the consumer, while persuasive
advertising is not; though in practice it may be hard to
distinguish between the two.
Firms engage in advertising for a number of reasons
 First, they try to change consumer preferences by persuading
consumers of the superior quality of their product by providing
information about it and by promoting brand loyalty.
• As a consequence, the firm promotes extra sales or is able to sell its
product at a higher price.
 In addition, the firm may be able to lower average costs of
production by producing and selling more output, thereby
increasing profits. Advertising is designed to alter the
consumer’s preferences in favor of advertised products and
against non-advertised products.
 Advertising is often the principal method
employed by firms to increase perceived
differences between products among
consumers and to create brand loyalty.
 Therefore, it is a major competitive tool,
especially when used in combination with other
competitive weapons, such as price reduction.
 In some oligopolistic markets, variations in
advertising expenditure are thought to be more
important than lowering price in trying to sell
more of a product.
• Advertising is undertaken to stimulate demand and,
thereby, lower the price elasticity of demand for the
product.
 If consumers are persuaded to buy more of a good at
every price, so that the demand curve shifts outward
to the right, then consumers will buy more at the
current price; but, the price elasticity of demand on a
linear demand curve will have fallen.
 Alternatively, the firm can charge a higher price for
the same level of output.
 Another motive for advertising is to lower average
production costs as a consequence of selling more
output.
 A firm with a short-run, U-shaped cost curve will
face lower costs if it sells more, providing it is
operating on the downward-sloping segment of the
average cost curve.
 If the firm is also on the downward portion of its
long-run average cost curve, then significant
increases in sales could lead to larger production
facilities being constructed and further falls in
average production costs.
 Advertising is also an expense, and the average
unit expenditure on advertising may more than
offset the reductions in production costs achieved
by selling more.
 The relationship between sales and
advertising expenditure can be expressed as
a ratio.
 The average ratio would be measured by S/A,
where S is total sales revenue and A is total
advertising expenditure.
 The marginal relationship between sales and
advertising expenditure is given by S/A.
 Baumol, in his sales maximization model,
assumed that the marginal-sales-to-advertising
ratio was always positive and greater than 1.
 This assumption means that all advertising
campaigns are successful.
 In practice, advertising campaigns can be
unsuccessful; this is indicated in two ways:
 first, a positive advertising-to-sales ratio of less
than 1 would indicate that sales revenue had
increased by less than the increase in
advertising expenditure; and,
 second, a negative sales-to-advertising ratio would
indicate that an increase in advertising
expenditure had led to a decline in sales.
 It is expected that advertising initially generates a
S/A ratio of substantially greater than 1, but that
the ratio declines with successive increments in
spending.
 The declining responsiveness of demand to a
change in advertising expenditure may be linked to:
The life cycle of the product and its falling growth rate
as consumers satiated with the product, cease buying
for the first time and buy only for replacement reasons.
The perceived requirement of competitors to spend
heavily on advertising to maintain or increase their
market share in a declining market, because of the
unwillingness of consumers as a result of brand loyalty
to switch from one brand to another.
 1.2 Effectiveness of Advertising as a Market Weapon
 Many theorists believe there to be chain reactions of
advertising effects which arise from learning and
attitude-change through the purchase and repurchase
stages to the final impact on a firm’s sales and profits.
 For this let us consider the basic functions
advertising performs in marketing a product to a
consumer.
 Familiarise: making a product well known to the
consumer. This minimises the fear of the unknown, by
reducing uncertainty.
 Reminding: re-announcing the brand’s intrinsic values
to consumers who already use it.
 Spreading news: this is the stereotyped role of advertising,
announcing new products, changes in the existing product, price
reductions and new sizes or colours.
 Overcoming inertia: for example, exercises where the rewards
are remote and the costs are immediate. Advertising can provide a
simulated experience of the reward, on the same principles as a
virtual reality computer game.
 Adding a value not in the product: it may be argued that
advertising creates genuine and real values that are, nevertheless,
purely subjective. This is not surprisingly the most controversial
function of advertising. The persuasiveness of messages is
difficult if not impossible to quantify. This creates a difference of
opinion as to whether advertisement is informative or persuasive.
 The next section tries to explain three views about
advertisement.
 Is Advertising Informative or Persuasive?
• Three views of advertising emerged in the economics
literature. These are the persuasive view, the informative
view and the complementary view.
 The Persuasive View
• The persuasive view holds that advertising primarily
affects demand by changing tastes and creating brand
loyalty.
• The advertised product thus faces a less elastic demand.
• This elasticity effect suggests that advertising causes
higher prices, though this influence may be moderated by
the presence of production scale economies.
• The persuasive view holds further that advertising may
deter entry.
 Consumers are reluctant to try new products
of unknown quality, and this experience-
based asymmetry between established and new
products may be exacerbated in the presence
of heavy advertising by established firms.
 Advertising may be particularly effective in
this regard if there are scale economies in
advertising or production.
 The Informative View
 The informative view holds that advertising primarily
affects demand by conveying information.
 The advertised product thus faces a more elastic
demand.
 This elasticity effect suggests that advertising causes
lower prices, an influence which is reinforced when
production scale economies are present.
 The informative view suggests further that advertised
products are generally of high quality, so that even
seemingly uninformative advertising may provide the
indirect information that the quality of the advertised
product is high.
 There are three reasons.
 First, the demand expansion that advertising induces is most
attractive to efficient (low-cost) firms, and such firms are
likewise attracted to demand expansion achieved by offering
low prices and high-quality products.
 Second, the product experience memories that advertising
renews are most valuable to firms with high-quality products,
since repeat purchases are then more likely.
 Third, a firm sensibly targets its advertising toward consumers
who would value its product most.
 The informative view holds further that advertising is not used
by established firms to deter entry; instead, advertising
facilitates entry, since it is an important means through which
entrants provide price and quality information to consumers.
 The Complementary View
• Finally, the complementary view holds that advertising
primarily affects demand by exerting a complementary
influence in the consumer’s utility function with the
consumption of the advertised product.
• As an example, it may be that a consumer values “social
prestige”, and advertising may then serve as an input that
enables the consumer to derive more social prestige when
the advertised product is consumed.
• The complementary view is logically distinct from the
persuasive view, since the complementary view:
 holds that consumers possess a stable set of preferences into
which advertising enters as one argument.
 advertising may affect consumer demand even if it contains no
(direct or indirect) information.
 An important benefit of the complementary
view is that the fixed-preferences assumption
permits a straightforward welfare analysis of
seemingly persuasive (or at least
uninformative) advertisements.
 Under this view, the market may provide too
little advertising, since the advertising firm
does not internalize the full increase in
consumer surplus that its advertising
engenders.
 Optimal Level of Advertising or Measuring Advertising
Intensity
 In imperfectly competitive markets, competition between
firms is based on using a combination of advertising,
price and product characteristics.
 If the firm can adjust both price and advertising
expenditure, then the firm is able to use a combination of
both to compete with its rivals.
 To maximize profits a firm will equate marginal revenue
to marginal cost whether it advertises or not.
 The optimal level of advertising expenditure for the
firm is determined where the marginal increase in costs
of advertising is equal to the marginal increase in
revenue.
 The practicability of this rule requires the
assumption that the firm will know with
certainty the nature of the cost and revenue
functions required to determine the optimal
level of advertising.
 In practice, however, this is rarely possible due
to the lack of detailed disaggregated data
and the cost of obtaining such information.
 In addition, the firm in the models outlined is
able to reach decisions without taking into
account the possible reactions of its rivals.
 Advertising expenditure may have an impact on consumer
preferences and sales in more than one period.
 Some consumers may react instantly to the message of the
campaign; others may react more slowly and may only remember
the advertising content when they consider purchasing the
product sometime in the future.
 For example, infrequently purchased items may only be replaced
when they cease working or fashions change.
 Few households replace fireplaces or baths frequently, but when
they come to do so they may remember the advertisement.
 Advertising in one period, therefore, can have an impact on sales
in future periods because advertising builds continued awareness
of the product or firm among consumers.
 By capturing the delayed response on the part of consumers from
each campaign, a cumulative effect on sales may be observed.
 The conditions for optimal advertising outlined
earlier were based on the assumption that all
effects occurred in one time period.
 Clearly, the greater the impact of advertising within
one period the more relevant will the analysis be.
 But, the greater the impact of the advertising in
subsequent periods the less relevant will the
analysis be.
 Giving consideration to future impacts would
justify higher levels of advertising in the initial
period than the single period analysis might
suggest.
 Advertising and Market Structure
 One of the factors determining the level of a firm’s advertising
expenditure is the size and number of competitors in the
market.
 If the firm sells a homogeneous product in a perfectly
competitive market, then advertising would appear to be
unnecessary.
 However, if consumers are not perfectly informed, then industry-
wide advertising would make sense to overcome this deficiency.
 At the other extreme, a monopolist would likewise hardly need
to advertise because consumers would have no other source of
the product.
 In practice, a monopolist may advertise to encourage
consumers to buy more of its products in particular, rather than
on other products in general.
• Therefore, the market structures in which advertising
might be expected to be a significant competitive
weapon will be those ranging from monopolistic
competition to duopoly where products are
differentiated and there are relatively few
competitors.
• In monopolistically competitive markets, products are
differentiated; this means that, although there is large
number of competitors, each firm’s product is not a
perfect substitute for the products of other suppliers.
• The demand for each firm’s product tends to be more
price-inelastic than in more competitive markets and
the advertising-to-sales ratio would be higher.
 In oligopolistic markets with differentiated
products, similar considerations apply.
 Therefore, the expectation is that advertising-
to-sales ratios will be low in uncompetitive
markets and monopoly, but higher in
imperfectly competitive markets where
products are differentiated.
• This relationship is illustrated in Figure 6 .1,
where market concentration is measured on
the horizontal axis and the advertising-to-sales
ratio on the vertical axis.
Figure 6.1: Advertising and Market Structure
 If a firm gains an increased market share in a rapidly
expanding market by advertising, then it will experience
growth.
 It will also gain market power and be expected to have a
higher price–cost margin.
 Thus, larger firms will have higher profit rates than smaller
firms.
 Having achieved higher profits through increasing its
advertising-to-sales ratio, the firm may continue to increase its
ratio because it makes life difficult for its less successful rivals
to maintain their position.
 High advertising-to-sales ratios, which are difficult for smaller
rivals to match, may also deter potential entrants to the
market; this creates a barrier to entry against potential entrants.
• Thank you for your attention @
being an economist in all your
journey!!!