Lecture 13 Slides

```Lecture 13: Advertising and Pricing
AEM 4160: Strategic Pricing
Prof.: Jura Liaukonyte
 Assume a
firm faces a downward-sloping demand
inverse curve but one that shifts depending on the
amount of advertising A that the firm does
P=P(Q, A)
•Recall, the Lerner Index, LI
L = (p - MC)/p = 1/|EP|
Where |EP| is the price elasticity of demand
 The elasticity of
output demand with respect
to advertising A is defined as
Q / Q
A Q
EA 

A / A
Q A
• We can derive the following relationship:
A
EA

P * Q | Ed |
Dorfman-Steiner Condition: For a profit-maximizing
monopolist, the advertising-to-sales ratio is equal to the
ratio of the elasticity of demand with respect to
advertising relative to the elasticity of demand with
respect to price.
Intuition behind D-S
A
EA

P * Q | Ed |

Recall: the greater the demand elasticity, the lower the optimal price.

price-cost margin is smaller when elasticity is higher. Since the pricecost margin is smaller with elastic demand, the gain from advertising is
also smaller even if the increase in quantity demanded is the same.

The marginal gain from advertising is greater the greater the price-cost
margin.
Dorfman-Steiner

The Dorfman-Steiner formula relates the advertising-to-revenues
ratio to price-cost margin and ADVERTISING elasticity.

elasticity of demand and lower the price elasticity of demand (or
the greater the price-cost margin).
Example

Suppose you have been hired to market a new music recording that is
expected to have target sales of \$20 million for upcoming year

The marketing department has estimated that 1% increase in advertising
will translate to 0.5% increase in sales

And that 1% increase in the price of the recording would reduce the

How much money should you commit to advertising the recording in the
coming year?

This ratio varies between industries.

salt industry: a-s-r = 0 to .5%

breakfast cereals industry: a-s-r= 8% to 13%

the type of product.


price elasticity of demand

The Dorfman-Steiner Condition is the starting point
market power. It yields several important insights

Recall that the Lerner Index LI=(P – c)/P =1/|ED|

Hence, we can write the Dorfman-Steiner condition as:


The observed positive correlation between advertising
intensity and market power

Industries with high responsiveness of sales to advertising (high EA)

Advertising similarity across industries and over time is to
be expected if EA and ED are similar

Each firm’s advertising elasticity decreases as concentration
decreases.

The more fragmented the industry is, the lower the benefit from
advertising that is captured by the firm that pays for it.

With more firms in the industry, a firm’s "split of the pie" is
smaller.

differentiation.

differences.

Firms can create some sort of subjective product difference.

Advertising in this case softens competition due to heightened
awareness of product differentiation.
◦
◦

soften competition: the industry is less competitive and firms have
more market power.
strengthen competition: the industry is more competitive and firms
have less market power.
Firms are able to avoid Bertrand competition by advertising.

prices.

If prices were artificially high due to imperfect price information, then firms
have an incentive to advertise about their prices to attract more consumers.

higher expenditures on advertising and lower prices.

Advertising in this case strengthens competition due to heightened
awareness of prices.
a characteristic of mature
markets, is defined as advertising that shifts consumer
preferences towards the advertising firm, but does not
expand the category demand.


Redistributes consumers among brands. If the real differences
between brands are modest, then combative advertising may be
excessive.

Basis of Prisoner's dilemma in advertising.
 The
 Everyone
to equalize the effects
would gain if no one advertised
each other. Each firm’s ad cancels out the effects of the
other, and both firms’ profits fall by the cost of the ads.
 All
US tobacco companies
1964
 Surgeon General issues official
 Cigarette smoking may be hazardous
1970
warning
 Cigarette companies fear lawsuits
 Government may recover healthcare costs
 Companies strike agreement
 Carry the warning label and cease TV advertising in
exchange for immunity from federal lawsuits.
 After
the 1970 agreement:
by \$63 million
 Industry Profits rose by \$91 million
 Prisoner’s
 An
Dilemma
equilibrium is NOT necessarily efficient
 Players can be forced to accept
outcomes
 Bad to be playing a prisoner’s dilemma,
but good to make others play
Strategic Interaction
 Players:
Reynolds and Philip Morris
 Payoffs:
 Strategic
Companies’ Profits
Landscape:
 Each firm earns
\$50 million from its customers
 Advertising costs a firm \$20 million
 Advertising captures \$30 million from competitor
 How
to represent this game?
Representing a Game
PLAYERS
Philip Morris
50 , 50
20 , 60
60 , 20
30 , 30
Reynolds
STRATEGIES
PAYOFFS
What to Do?
Reynolds
Philip Morris
50 , 50
20 , 60
60 , 20
30 , 30
If you are advising Reynolds, what strategy do you recommend?
Solving the Game
Reynolds

Philip Morris
50 , 50
20 , 60
60 , 20
30 , 30


If Philip Morris does not advertise:
Prisoner’s Dilemma
Optimal
50 , 50
60 , 20
20 , 60
30 , 30
Equilibrium

Both players have a dominant strategy

The equilibrium results in lower payoffs for each player
Equilibrium Illustration
The Lockhorns
24
Persuasive
Informative
Complimentary
Memory
Jamming (Reminder)

The persuasive view holds that advertising alters consumers' tastes and
creates spurious product differentiation

The demand for a firm's product becomes more inelastic


Such advertising by established firms may give rise to a barrier to entry,
which is naturally more severe when there are economies of scale in
production and/or advertising differentiation and brand loyalty.
Model of Advertising and Crowd Appeal
*
\$
Demand with

Profit
Demand without
MC
Quantity
 Increase in
consumers’ willingness to pay is a function of the
 As
s increases, WTP increases, as does consumer demand and
profit.
 Firms will select the
level of advertising that maximizes profit,
i.e., the level of advertising where the marginal revenue from
Complementary View
 Consumers possess
stable preferences
preferences in a manner that
is complementary to the consumption of the advertised
product.
information and influence consumer
behavior for that reason.
 The
consumer may value “social prestige” that is created by
Complementary vs. Persuasive

The lines between complementary and persuasive are blurred,
because it is hard to know whether ads change preferences or are
part of consumer’s utility.
Complementary View

An implication is that:


firms may compete in the same commodity (e.g., prestige) market even
though they produce different market goods (e.g., jewelry and fashion)
Component of most luxury goods marketing.
Mission Statement
“Louis
Vuitton must continue to be
synonymous with both elegance and
creativity. Our products, and the cultural
values they embody, blend tradition and
innovation, and kindle dream and fantasy.”
Informative View
attractive to firms as a means through which
they may convey information to consumers.
reduces consumers' search costs,
since it conveys information about products.

pro-competitive consequences.
Advertising is a valuable source of information for consumers that
results in a reduction in price dispersion
\$
Demand with
Profit
Demand with low
MC
Quantity
 As
ad expenditures increase, so does demand and profit.