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.