PRICE AND NON-PRICE STRATEGIES
Examples Pharmaceutical sector - Similar expenses in marketing activities and in R&D - Necessary marketing expenses? Wasteful? Soft drinks - Price competition plays a secondary role wrt advertising competition
In this chapter - Advertising is considered with a strategic perspective
III.4.1 INFORMATION, PERSUASION, SIGNALING
To analyze the possible effects of advertising, classify goods in 3 categories: - Search goods (PC) - Experience goods (restaurants) - Credence goods (medical services)
Classify advertising activities: - Informative advertising (information about characteristics) - Persuasive advertising (to influence consumers’ preferences)
Links: - Informative advertising mainly associated with search goods - Empirical evidence: advertising/sales ratio is 3x higher for experience goods than it is for search goods
Social value of advertising? - Is informative advertising the only one with social value? - Look for efficiency arguments
Signaling - Persuasive advertising can be considered as an indirect informative advertising for some experience goods - Example: Ford, Diet Coke at launch - At launch, we have very little information - We only know that advertising is expensive
Signaling - Advertising expenditure can signal quality - Ingredients: ! dynamic perspective (does not work for one-period goods) ! Experience goods (no information about the quality, the characteristics) - Signaling theory: ! Averse selection ! Market failure ! Signaling ! Credibility, interpretation of signals ! Signals expensive enough, not too much
III.4.2 ADVERTISING INTENSITY
- To measure advertising intensity, compute a/R, where a are the advertising expenses and R is the revenue from sales. - Examples: ! In the salt industry, a/R is of the order of 0% to 0.5% ! For breakfast cereals, it is between 8% and 13% (Sutton’s estimates) - How do we explain such differences?
Factor 1: Demand elasticity w.r.t. advertising
- Consider the following demand: D(a, p) - Define demand elasticity w.r.t. advertising as
∂D(a, p) a η= ∂a D(a, p) - Some markets are more sentitive/reactive to variations in advertising than others.
q Low η
q High η
Factor 2: Demand elasticity w.r.t. price
- Consider the following demand: D(a, p) - Define demand elasticity w.r.t. price as
∂D(a, p) p ε= ∂p D(a, p) - Some markets are more sentitive/reactive to variations in prices than others. - Advertising is € more effective in markets with a low price elasticity of demand because prices are generally higher in such markets.
Also, ads can decrease the price elasticity of demand p
q Low ε
q High ε
Max Π = ( p − c)D( p, a) − a p, a
FOC w.r.t. p implies the inverse elasticity rule
FOC w.r.t. a implies
p−c 1 = p ε
a p−c = η R p
Combining both FOC, we obtain the Dorfman-Steiner formula:
a η = R ε
- Advertising intensity increases with η and decreases with ε.
- Empirical support
Factor 3: Market structure Higher advertising intensity in concentrated markets or in more competitive markets? How do ε and η vary with the number of firms, n?
- ε increases with the number of firms, n ! By decreasing its price, a firm not only increases total demand, but also its market share. ! The second effect is greater for smaller firms. ! Therefore, price elasticity of demand is higher in markets with many small firms. ! Advertising intensity is therefore lower in markets with many firms.
- How does η vary with the number of firms, n? 2 extreme cases 1. If advertising increase the demand for all firms equally ! Examples: milk, diamonds ! Advertising = public good ! The higher n, the more we share the benefits from advertising ! η decreases with the number of firms, n ! Less incentives to invest in advertising when n is high ! Example: Diamonds (distribution by DeBeers vs Russian producers)
2. The total demand is given, only market shares vary (Hotelling) ! Examples: pharmaceuticals ! Effect of ads: consumers switch from brand-name drugs to generics ! In a monopoly, η = 0 ! In a duopoly, η > 0 ! In a concentrated market, η increases with the number of firms, n ! More incentives to invest in advertising when n increases
To sum up, as n increases, we have 3 effects: - markets shares are lower, ε is higher, a/R decrease - Each firm captures a smaller share of the positive effect of advertising - Hotelling
" The total effect is ambiguous.
Empirically: - For high initial n, advertising intensity decreases with n - For low initial n, advertising intensity increases with n
III.4.3 PRICE COMPETITION AND ADVERTISING
Interactions between the advertising strategies of competing firms.
- Prisonners dilemma for advertising expenses (as for price setting) - If total demand is constant (Hotelling), each firm engages in advertising until profits are zero - Idem Bertrand competition - This result on advertising can be nuanced in the same way as the Bertrand results - Example: repeated interactions can decrease such wasteful advertising activities.
Collusion and advertising strategies
- Different timing between advertising strategies and price strategies: ! Decisions: frequent for prices, less frequent for advertising ! Effects: short-term for prices, long-term for advertising ! Time-discount factor likely to be lower for advertising activities ! A collusive agreement on advertising activities is more difficult to sustain than one on prices
Interaction between price competition and advertising competition
- Advertising can soften price competition ! Generally, persuasive advertising increases product differentiation ! Therefore, it softens price competition ! Not only is advertising wasteful, but it is also anti-competitive ! But, how do we compare total surplus with and without advertising if consumer preferences vary? ! Moreover, advertising increases the exchanged quantities, which argues in favor of advertising, even persuasive
- Advertising can intensify price competition ! Informative advertising on prices decreases search costs ! Therefore, price competition intensifies ! But then, why would firm invest in such informative advertising? ! Prisonners dilemma again?