AEM 4550: Economics of Advertising Prof. Jura Liaukonyte

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LECTURE 4 5 PRODUCT DIFFERENTIATION AND
PERSUASIVE ADVERTISING

• AEM 4550Economics of AdvertisingProf. Jura
  Liaukonyte

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Lecture Plan

• LI and Dorfman Steiner revisited
• Product differentiation and advertising
• Taxonomy of product attributes
• Search
• Experience
• Credence
• Taxonomy of advertising types
• Persuasive Advertising
• PBS Frontline Persuaders

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Lerner Index

• L (p - MC)/p 1/ED
• PUNCHLINE If elasticity increases, mark-up will
  decline. If the product becomes less elastic,
  mark-up will increase.

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Advertising and Monopoly Power

• Assume a firm faces a downward-sloping
  demandinverse curve but one that shifts
  depending on the amount of advertising A that
  the firm does
• PP(Q, A)

Recall, the Lerner Index, LI
L (p - MC)/p 1/EP
Where EP is the price elasticity of demand
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Advertising and Monopoly Power

• The elasticity of output demand with respect to
  advertising ?A is defined as

We can derive the following relationship
Advertising/sales ratio
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.
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Intuition Behind D-S

• Recall the greater the demand elasticity, the
  lower the optimal price.
• price-cost margin is smaller when elasticity is
  higher. Since the price-cost 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.

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Dorfman-Steiner

• The Dorfman-Steiner formula relates the
  advertising-to-revenues ratio to price-cost
  margin and 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).

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Example

• Suppose you have been hired to marker 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?

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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

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Highest Ad-to-Sales Ratios
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Lowest Ad-to-Sales Ratios
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Example

• Credit Card Industry

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Advertising to Sales Ratios

• Industry Average is 7.6 and has grown
• over the last few years

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Example

• Airline Industry

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Ad to Sales Ratios

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Ad to Sales Ratios

• High or low?
• Transportation/Travel industry 1.9
• Consumer Products, Books, PayTv, Communications,
  all gt 5
• Downward Trend

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Stylized Facts About Advertising

• Volume of advertising expenditures is large. For
  the US, advertising expenditures total to over
  2 of GDP
• Underneath this national total is a wide variety
  in firm advertising behavior
• Car makers (e.g., GM) and household product firms
  (e.g., Proctor Gamble) spend the most on
  advertising
• Basic patterns that emerge are
• Correlation between advertising market power
• Consistency of advertising behavior within
  industriesbig advertisers remain big over time
  and across countries

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Ad Elasticity and Concentration

• Each firms 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 firms "split
  of the pie" is smaller.

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Product Differentiation

• Products are different if there is some objective
  characteristic or property, real or perceived,
  that provides a basis for buyers to choose one
  over the other.
• Product differentiation may lead to reduced own
  -price elasticity. As the degree of
  differentiation increases, the price elasticity
  will decrease.

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Product Differentiation, cont.

• Ways in which products are differentiated.
• Product Brand
• Packaging
• Conditions of Sale
• Service Provided
• Location
• Product Differentiation as an Entry Strategy
• Product differentiation to create a niche market.
• Product differentiation to deter entry.

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Product Positions in Characteristics Space
What could advertising do to change these
positions? Are perceived and real characteristics
the same thing?
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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.

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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.

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Perceptual Maps
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Perceptual Map Credit Cards
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Perceptual Map Credit Cards
Uniformity
American Express
Selectivity
Accessibility
Chase
B of A
Citi
Variety
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• http//www.google.com/trends?qnook2Ckindle2Ci
  padctab0geoalldateytdsort0

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On the other hand

• 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.

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Taxonomy of Products and Their Attributes
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Understanding Customer

• Search attributes are those that a customer can
  determine prior to purchasing the goods and/or
  services. These attributes include things like
  color, price, freshness, style, fit, feel,
  hardness, and smell.
• Goods such as supermarket food, furniture,
  clothing, automobiles, and houses are high in
  search attributes.

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Understanding Customer

• Experience attributes are those that can be
  discerned only after purchase or during
  consumption or use.
• Examples of these attributes are friendliness,
  taste, wearability, fun, and customer
  satisfaction.

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Understanding Customer

• Credence attributes are any aspects of a good or
  service that the customer must believe in, but
  cannot personally evaluate even after purchase
  and consumption.
• Examples would include the expertise of a surgeon
  or mechanic, the knowledge of a tax advisor, or
  the accuracy of tax preparation software.

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Taxonomy of Goods-Nelson (1974), Lieberman and
Flint-Goor (1996)
Search Goods Non-Durable Exp. Goods Durable Exp. Goods Experience Services Credence Services
Clothing Furniture Footwear Carpets Mattresses Health/Beauty Cigarettes Food Cleaners Newspapers Office Supplies Housing Autos Hardware Drugs Glass Software Signs Books Sporting Goods Hobbies Utilities Advertising Transportation Vacations Education Training Tours Banking Car Rentals Entertainment Direct Mail Real Estate Cargo Job Placement Information Nursing Homes Sports Clubs Hotels Waste Collection Landscaping Investments Trusts Portfolio Management Mutual Funds Insurance Health Care Weight Control Car Repairs
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Key Point

• Firm (Brand) Reputation is more important for
  experience goods than search goods and most
  important for credence goods.
• Has implications on advertising effects on
  demand.

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Product Attributes
Most Goods
Most Services
Difficult
Easy
to evaluate
to evaluate
Computer repair Education Legal
services Complex surgery
Clothing Chair Motor vehicle Foods
Restaurant meals Lawn fertilizer Haircut Enter
tainment
High in search
High in experience
High in credence
attributes
attributes
attributes
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How the Internet affects

• Search goods
• Can facilitate consumers' ability to obtain
  attribute information.
• Experience goods
• Difficult to provide enough experience for
  consumers to assess the benefits of the product ?
  Offline trial Online purchase
• Credence goods
• How to help consumers form a set of beliefs about
  the quality of the product? ? Access to other
  people's beliefs about the quality of the product
  such as product testimonials

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Advertising Taxonomy

• Why do consumers respond to advertising?
• An economic theory of advertising can proceed
  only after this question is confronted.
• As economists have struggled with this question,
  3-4 views have emerged, with each view in turn
  being associated with distinct positive and
  normative implications.

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Main Views of Advertising

• Persuasive
• Informative
• Complimentary
• Memory Jamming (Reminder)

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Life Cycle of Product
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Persuasive Advertising
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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.

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Persuasive Advertising and Product Types

• Recall, reputation is more important for
  experience goods than search goods and most
  important for credence goods.
• Reputation and Persuasion are synonyms in this
  case.
• Among which type of products will we observe high
  levels of persuasive advertising?
• Search, Experience or Credence?

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The Pervasiveness of Persuasion

• The average person is exposed to 300-400
  persuasive messages per day from the media alone
  (Rosseli, Skelly, Mackie, 1995)
• The average person is exposed to 1,000
  commercials per week (Berger, 2004)
• An average of 800 per person is spent on
  advertising in the U.S. each year (Berger, 2004)

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Obvious Forms of Persuasion

• A 30 second spot for Super Bowl costs 3-4
  million for a 30 second spot.
• Product placements in movies and TV amounted to
  2.5 billion in 2005 (PQ Media).
• Morgan (2005) between 15-30 products are
  inserted in every half hour of television
  programming.

• Product Placement on American Idol

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Product Placement

• http//www.brandchannel.com/brandcameo_films.asp
• Featured Brands Apple, Bell, Cadillac, Chock
  Full ONuts, Chrysler, Cisco, Ford, Ford Mustang,
  Hill-Rom, HP, Lacoste, Listerine, Los Angeles
  Dodgers, Mercedes, Motorola, Pepsi, Philips,
  Pontiac, Pyrotect, Rolls Royce, San Francisco
  Giants, Sharp, The North Face, The Riviera Hotel
  and Casino, Timberland, Toyota, United States
  Parachute Association

• Featured brands Apple, Belstaff, BMW, Citibank,
  Datascope, Ford, Ford Mustang, Hamilton, Honda,
  Hummer, JVC, Kleenex, Loews, Magnavox,
  McDonald's, MetLife, Mobil, Nautilus, NBC,
  Nissan, Panasonic, Ronzoni, Salvatore Ferragamo,
  Sbarro, Spam, Staples, Tic Tac, Time, Verizon,
  Viking, XM Satellite Radio

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Model of Persuasive Advertising

• Total of N consumers in the market.
• Each consumer will buy only one unit of the
  primary good.
• Each consumer has a different value, vi, for the
  primary good.
• Advertising increases each consumers value by
  the same factor, ?, regardless of their initial
  value. Thus each consumers value with
  advertising is ? vi.

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Model of Advertising and Crowd Appeal
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Model of Persuasive Advertising

• Increase in consumers willingness to pay, ?, is
  a function of the amount spend on advertising, s.
  
• As s increases, ?(s) increases, as does consumer
  demand and profit.
• Firms will select the level of advertising that
  maximizes profit, i.e., the level of s where the
  marginal revenue from s is equal to the marginal
  cost of s.

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Model of Persuasive Advertising

• In this model, higher levels of advertising lead
  to higher prices because the advertising
  increases the consumers willingness to pay.
• Also, advertising can increase consumer surplus
  as well as firm profit, since advertising
  increases a consumers value.
• More about that later, when we talk about
  complementary view.

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PBS Frontline PERSUADERS

• http//www.pbs.org/wgbh/pages/frontline/shows/pers
  uaders/