Chapter 28
`
`THE ECONOMIC ANALYSIS OF ADVERTISING
`
`KYLE BAGWELL
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`Columbia University
`
`Contents
`
`Abstract
`Keywords
`1. Introduction
`2. Views on advertising
`2. I. Setting the stage
`2.2. The persuasive view
`2.3. The informative view
`2.4. The complementary view
`2.5. Summary
`2.5.1. Combative advertising
`2.5.2. Persuasion and consumption distortions
`2.5.3. Joint supply
`2.5.4. Brand loyalty, advertising scale economies and market power
`3. Empirical regularities
`3.1. The direct effects of advertis.ing
`3.1.1. Sales
`:'1.1.2. Brand loyalty and market-share stabi lity
`3.1. 3. Advertising scale economies
`3.2. The indirect effects of advertising
`3.2.1. Concentration
`3.2.2. Profit
`3.2.3. Entry
`3.2.4. Price
`3.2.5. Quality
`3.3. Summary
`4. Monopoly advertising
`4.1 . The positive theory of monopoly advertising
`4. l. l. The Dorfman-Steiner model
`
`Handbook of Industrial Organization, Volume 3
`Edited by M. Armstrong and R. Porter
`© 2007 Elsevier B. V. All rights reserved
`DOl: 10.1016/Sl573-448X(06)03028-7
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`4. 1.2. Two examples
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`4.2. The normative theory of monopoly advertising
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`4.2. l. The persuasive view
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`4.2.2. An al.ternative approach
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`4.2.3. Price-maintaining and price-decreasing monopoly advcnis.ing
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`4.2.4. Price-increasing mo nopoly advertising
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`4.3. Summary
`5. Advertising and price
`5.1. Homogeneous products
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`5.2. Differentiated products
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`5.3. Non-price advertising
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`5.4. Loss leaders
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`5.5. Summary
`6. Advertising and quality
`6. I. Signaling-efficiency effect
`6.2. Repeat-business effect
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`6.3. Match-products-to-buyers effect
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`6.4. Quality-guarantee effect
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`6.5. Summary
`7. Adverti sing and entry deterrence
`7.1. Advertising and goodwill
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`7.2. Advertising and signaling
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`7.3 . Surnnmry
`8. Empirical analyses
`8.1. Advertising and the household
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`8.2. Advertisi ng and firm conduct
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`8.3. Summary
`9. Sunk costs and market structure
`9.1. Main ideas
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`9.2. Econometric tests and industry histories
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`9.3. Related work
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`9 .4. Summary
`I 0. New directions and other topics
`1 0.1. Advertising and media markets
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`I 0.2. Advertising, behavioral economics and neuroeconomics
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`1 0.3. Other topics
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`10.4. Summary
`II. Conclusion
`Acknowledgements
`References
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`Ch. 28: The Economic Analysis of Advertising
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`Abstract
`
`This chapter offers a comprehensive survey of the economic analysis of advertising.
`A first objective is to organize the literature in a manner that clarifies what is known.
`A second objective is to clarify how this knowledge has been obtained. The chap(cid:173)
`ter begins with a discussion of the key initial writings that are associated with the
`persuasive, informative and complementary views of advertising. Next, work that char(cid:173)
`acterizes empirical regularities between advertising and other variables is considered.
`Much of this work is conducted at the inter-industry level but important industry stud(cid:173)
`ies are also discussed . The chapter then offers several sections that summarize formal
`economic theories of advertising. In particular, respective sections are devoted to pos(cid:173)
`itive and normative theories of monopoly advertising, theories of price and non-price
`advertising, theories of advertising and product quality, and theories that explore the
`potential role for advertising in deterring entry. At this point, the chapter considers the
`empirical support for the formal economic theories of advertising. A summary is pro(cid:173)
`vided of empirical work that evaluates the predictions of recent theories of advertising,
`including work that specifies and estimates explicitly structural models of firm and con(cid:173)
`sumer conduct. This work is characterized by the use of industry (or brand) and even
`household-level data. The chapter then considers work on endogenous and exogenous
`sunk cost industries. At a methodological level, this work is integrative in nature: it
`develops new theory that delivers a few robust predictions, and it then explores the em(cid:173)
`pirical relevance of these predictions at both inter-industry and industry levels. Finally,
`the chapter considers new directions and other topics. Here, recent work on advertising
`and media markets is discussed, and research on behavioral economics and neuroeco(cid:173)
`nomi cs is also featured. A final section offers some concluding thoughts.
`
`Keywords
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`Advertising, Survey, Theory, Empirical analysis
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`JEL classification: M300, LlOO, D800
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`"What makes the advertising issue fascinating . . . is that it is fundamentally an issue in how to establish
`truth in economics." (Phill ip Nelson, l974a)
`
`1. Introduction
`
`By its very nature, advertising is a prominent feature of economic life. Advertising
`reaches consumers through their TV sets, radios, newspapers, magazines, mailboxes,
`computers and more. Not surprisingly, the associated advertising expenditures can be
`huge. For example, Advertising Age (2005) reports that, in 2003 in the U.S., General
`Motors spent $3.43 bi11ion to advertise its cars and trucks; Procter and Gamble devoted
`$3.32 billion to the advertisement of its detergents and cosmetics; and Pfizer incurred a
`$2.84 billion advertising expense for its drugs. Advertising is big business indeed.
`From the current perspective, it is thus surprising to learn that the major economists
`of the 19th century and before paid little attention to advertising. The economic analy(cid:173)
`sis of advertising is almost entirely a 20th-century project. Why did not 19th-century
`economists analyze advertising? Two reasons stand out.
`First, 19th-century economic research is devoted largely to the development of the
`theory of perfect competition, and this theory does not immediately suggest a role for
`advertising. As Pigou (1924, pp. 173-174) remarks, "Under simple competition there
`is no purpose in this advertisement, because, ex hypothesi, the market will take, at the
`market price, as much as any one small seller wants to sell". Of course, whether a firm
`is competitive (i.e., price-taking) or not, it might advertise if it were thereby able to
`shift its demand curve upward so that a higher price could be obtained. But here a more
`basic problem arises: under the conventional assumptions that consumers have fixed
`preferences over products and perfect information with regard to prices and qualities,
`there is no reason for consumers to respond to advertising, and so the posited demand
`shift is unjustified. 1
`Second, while advertising has long been used by merchants, its transition to "big
`business" is more modern . In the late 19th and early 20th centuries, following signif(cid:173)
`icant advances in transportation (railroads) and communication (telegraph) networks,
`manufacturers were motivated to pursue innovations in the machinery of production
`and distribution, so that economies of scale could be reaped. These economies, how(cid:173)
`ever, could be achieved only if demand were appropriately stimulated. The turn-of(cid:173)
`the-century technological innovations that are associated with mass production and
`
`1 As Braithwaite (l928, p. 28) explains: "Under conditions of perfect competition producers would gain
`nothing by spendi ng money on advertisement, for those conditions assume two things - (1) that the demand
`curve is fixed and cannot be altered directly by producers, and (2) that since producers can sell all that they
`can produce at the market price, none of them could produce (at a given moment) more at that price than they
`are already doing".
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`Ch. 28: The Economic Analysis of Advertising
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`distribution thus gave significant encouragement to large-scale brand advertising and
`mass marketing activities. 2
`At the beginning of the 20th century, advertising was thus a ripe topic for economic
`research. The economic analysis of advertising begins with MarshalJ (1890, 1919),
`who offers some insightful distinctions, and then gathers momentum with Chamber(cid:173)
`lin's (1933) integration of selling costs into economic theory. Over the second half of
`the century, the economic analysis of advertising has advanced at a furious pace. Now,
`following the close of the 20th century, a substantial literature has emerged. My purpose
`here is to survey this literature.
`In so doing, I hope to accomplish two objectives. A first objective is to organize the
`literature in a manner that clarifies what is known.3 Of course, it is impossible to sum(cid:173)
`marize all of the economic studies of advertising. Following a century of work, though,
`this seems a good time to bring to the surface the more essential contributions and take
`inventory of what is known. Second, I hope to clarify how this knowledge has been
`obtained. The economic implications of advertising are of undeniable importance; how(cid:173)
`ever, the true nature of these implications has yielded but slowly to economic analysis.
`There is a blessing in this. With every theoretical and empirical methodological inno(cid:173)
`vation in industrial organization, economists have turned to important and unresolved
`issues in advertising, demonstrating the improvements that their new approach offers.
`Advertising therefore offers a resilient set of issues against which to chart the progress
`gained as industrial organization methods have evolved.
`It is helpful to begin with a basic question: 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, three views have emerged, with each
`view in turn being associated with distinct positive and normative implications.
`The first view is that advertising is persuasive. This is the dominant view expressed
`in economic writings in the first half of the 20th century. The persuasive view holds that
`advertising alters consumers' tastes and creates spurious product differentiation and
`brand loyalty. As a consequence, the demand for a firm's product becomes more inelas(cid:173)
`tic, and so advertising results in higher prices. In addition, 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. The persuasive approach therefore
`suggests that advertising can have important anti-competitive effects, as it has no "real"
`
`2 The emergence of large-scale advertising is also attributable to income growth, printing and literacy ad(cid:173)
`vances, and urbanization. See also Borden (1942), Chandler (1990), Harris and Seldon (1962), Pope (1983),
`Simon (1970) and Wood (1958).
`3 Surprisingly, there does not appear to exist another contemporary and comprehensive survey of the eco(cid:173)
`nomic analysis of advertising. Various portions of the literature are treated in other work. For example,
`Ekelund and Saurman (1 988) offer an interesting discuss.ion of early views on advertising by economists,
`and Cornanor and Wilson (1979) and Schrnalensee (1972) prov ide valuable surveys of early empirical analy(cid:173)
`ses. Tirole ( 1988) discusses in detail a few of the recent theories of advertising. Finally, in Volumes 1 and 2
`of the Handbook of Industrial Organization, Schmalcnscc (1989) provides further discussion of empirical
`findings, while Stiglitz ( 1989) offers some brief rcilcctions on the theory of advertising.
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`value to consumers, but rather induces artificial product differentiation and results in
`concentrated markets characterized by high prices and profits.
`The second view is that advertising is informative. This view emerged in force in
`the 1960s, under the leadership of the Chicago SchooL According to this approach,
`many markets are characterized by imperfect consumer information, since search costs
`may deter a consumer from learning of each product's existence, price and quality. This
`imperfection can lead to market inefficiencies, but advertising is not the cause of the
`problem. Instead, advertising is the endogenous response that the market offers as a so(cid:173)
`lution. When a firm advertises, consumers receive at low cost addi tional direct (prices,
`location) and/or indirect (the firm is willing to spend on advertising) information. The
`firm's demand curve becomes more elastic, and advertising thus promotes competition
`among established firms . As well, advertising can faci litate entry, as it provides a means
`though which a new entrant can publicize its existence, prices and products. The sug(cid:173)
`gestion here, then, is that advertising can have important pro-competitive effects.
`A third view is that advertising is complementary to the advertised product. Accord(cid:173)
`ing to this perspective, advertising does not change consumers' preferences, as in the
`persuasive view; furthermore, it may, but need not, provide information. Instead, it is
`assumed that consumers possess a stable set of preferences into which advertising en(cid:173)
`ters directly in a fashion that is complementary with the consumption of the advertised
`product. For example, consumers may value "social prestige", and the consumption of
`a product may generate greater prestige when the product is (appropriately) advertised.
`An important implication is that standard methods may be used to investigate whether
`advertising is supplied to a socially optimal degree, even if advertising conveys no in(cid:173)
`formation.
`These views are all, at some level, plausible. But they have dramatically different pos(cid:173)
`itive and normative implications. The persuasive and informative views, in particular,
`offer conflicting assessments of the social value of advertisi ng. It is of special impor(cid:173)
`tance, therefore, to subject these views to ri gorous empirical and theoretical eval uation.
`Over the past fifty years, the economic analysis of advertising, like the field of industrial
`organization itself, can be described in terms of a sequence of empirical, theoretical and
`again empirical evaluative phases.
`The empirical analysis of advertising was at center stage from the 1950s through the
`I 970s. Over this period, a voluminous literature investigated general empirical relation(cid:173)
`ships between advertising and a host of other variables, including concentration, profit,
`entry and price. Much of this work employs regression methods and uses inter-industry
`data, but important studies are also conducted at the industry, firm and even brand levels.
`This period is marked by vigorous and mostly edifying debates between advocates of
`the persuasive and informative views. The debates center on both the robustness and the
`interpretation of empirical findings, and they identify some of the limitations of regres(cid:173)
`sion analyses, particularly at the inter-industry level. While the inter-industry analyses
`are often inconclusive, defe nsible empirical patterns emerge within particular industries
`or narrow industry categories. The evidence strongly suggests that no single view of
`advertising is valid in ail settings.
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