Lecture 13 Slides

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Lecture 13: Advertising and Pricing
AEM 4160: Strategic Pricing
Prof.: Jura Liaukonyte
Advertising and Monopoly Power
 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
Advertising and Monopoly Power
 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

= Advertising/sales ratio
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.

The advertising-to-sales ratio is greater the greater the advertising
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
number sold by about 2%

How much money should you commit to advertising the recording in the
coming year?
Advertising to Sales Ratios

This ratio varies between industries.

salt industry: a-s-r = 0 to .5%

breakfast cereals industry: a-s-r= 8% to 13%
Advertising intensity depends on:

the type of product.

advertising elasticity of demand

price elasticity of demand
Highest Ad-to-Sales Ratios
Lowest Ad-to-Sales Ratios
Advertising and Monopoly Power

The Dorfman-Steiner Condition is the starting point
for thinking about the relationship between advertising and
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:

Advertising-to-Sales Ratio = EALI

The observed positive correlation between advertising
intensity and market power

Industries with high responsiveness of sales to advertising (high EA)
will have high advertising intensity

Advertising similarity across industries and over time is to
be expected if EA and ED are similar
Ad Elasticity and Concentration

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.
Advertising and Product Differentiation

Advertising product characteristics increases product
differentiation.

Consumers are more informed about objective product
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.
Advertising and Price

Advertising can increase price competition when firms advertise about their
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.

Rival firms will soon follow suit and advertise about their prices. This leads to
higher expenditures on advertising and lower prices.

Advertising in this case strengthens competition due to heightened
awareness of prices.
Supply Side: Combative advertising
 Combative advertising,
a characteristic of mature
markets, is defined as advertising that shifts consumer
preferences towards the advertising firm, but does not
expand the category demand.

Not about influencing the consumer preferences, but rather about
the supply side and advertising

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.
Advertising Wars
 The
prisoner's dilemma applies to advertising
 All firms advertising tends
 Everyone
to equalize the effects
would gain if no one advertised
 Advertising Wars
Two firms spend millions on TV ads to steal business from
each other. Each firm’s ad cancels out the effects of the
other, and both firms’ profits fall by the cost of the ads.
Cigarette Advertising on TV
 All
US tobacco companies
advertised heavily on TV
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.
Cigarette Advertising
 After
the 1970 agreement:
 Cigarette advertising decreased
by $63 million
 Industry Profits rose by $91 million
 Prisoner’s
 An
Dilemma
equilibrium is NOT necessarily efficient
 Players can be forced to accept
mutually bad
outcomes
 Bad to be playing a prisoner’s dilemma,
but good to make others play
Strategic Interaction
 Players:
Reynolds and Philip Morris
 Strategies: Advertise or Not Advertise
 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
No Ad
Ad
No Ad
50 , 50
20 , 60
Ad
60 , 20
30 , 30
Reynolds
STRATEGIES
PAYOFFS
What to Do?
Reynolds
No Ad
Ad
Philip Morris
No Ad
Ad
50 , 50
20 , 60
60 , 20
30 , 30
If you are advising Reynolds, what strategy do you recommend?
Solving the Game
Reynolds

No Ad
Ad
Philip Morris
No Ad
Ad
50 , 50
20 , 60
60 , 20
30 , 30
Best reply for Reynolds:


If Philip Morris advertises:
If Philip Morris does not advertise:
Prisoner’s Dilemma
Optimal
No Ad
Ad
No Ad
50 , 50
60 , 20
Ad
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
Demand Side views of advertising
Persuasive
Informative
Complimentary
Memory
Jamming (Reminder)
Persuasive Advertising
Persuasive Advetising

The persuasive view holds that advertising alters consumers' tastes and
creates spurious product differentiation

The demand for a firm's product becomes more inelastic

Advertising results in higher prices.

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
advertising

Profit
Demand without
advertising
MC
Quantity
Model of Persuasive Advertising
 Increase in
consumers’ willingness to pay is a function of the
amount spend on advertising.
 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
ads is equal to the marginal cost of ads.
Complementary View
 Consumers possess
stable preferences
 Advertising directly enters these
preferences in a manner that
is complementary to the consumption of the advertised
product.
 Advertising may contain
information and influence consumer
behavior for that reason.
 The
consumer may value “social prestige” that is created by
advertising
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)
and advertise at different levels.
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 Advertising
Informative View
 Advertising is
attractive to firms as a means through which
they may convey information to consumers.
 Advertising effectively
reduces consumers' search costs,
since it conveys information about products.
 Advertising may have

pro-competitive consequences.
Advertising is a valuable source of information for consumers that
results in a reduction in price dispersion
Model of Advertising as Information
$
Demand with
high advertising
Profit
Demand with low
advertising
MC
Quantity
Model of Advertising as Information
 As
ad expenditures increase, so does demand and profit.
 Firms select advertising
to maximize profit, i.e., where MR
from ads is equal to the MC of ads.
 In
this model, higher levels of advertising do not lead to
higher prices.
 Advertising does
increase total consumer surplus as well as
firm profit, since advertising increases the number of
consumers that get a surplus.

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