515

Chapter 22
_________________________
ADVERTISING AND COMPETITION
Anthony J. Dukes
-
This chapter provides an introduction to the economic analysis of advertising, providing
the foundation that is needed to understand how advertising relates to product
differentiation and to various antitrust theories that directly involve advertising. As
explained below, advertising is an important competitive tool that firms use to convey
information to potential purchasers about their products performance characteristics and
price. This makes advertising conduct an important market attribute.
1. Introduction
Advertising is an action through which firms communicate to the public. It involves
a variety of content (e.g., specific product details, product comparisons, image
enhancement, and quality signaling) and media (e.g., television, radio, Internet, print,
product packaging, and direct marketing). The information that is communicated may
relate to the price of a product or other product characteristics. Information about
product quality may be very direct or it may be signaled by association with other
things, including the price of the product or particular people. In fact, economists have
come to understand that a firms decision to advertise may offer a signal that provides
information beyond the content of the advertisement.
While pricing is often the focus of economic analyses of competitive conduct, firms
also use advertising to compete. In fact, U.S. firms spent over $285 billion on
advertising in 2006,
1
over 2 percent of the gross domestic product (GDP).
2
Given the
widespread use of advertising, it is not surprising that economists devote considerable
attention to studying advertising in the context of different product markets as well as to
studying advertising markets themselves. Economists have not only delved into why
firms advertise, but they have also studied the effect that advertising has on consumers
and on market performance. For example, economists have considered whether there is
too much or too little advertising.
As suggested above, economists recognize that different types of advertising convey
different types of information. Some advertising is designed to convey information
about the price of the product or its availability at certain locations. However, much
advertising is devoted to providing information about a products quality or trying to
persuade customers that a particular product would bring a variety of benefits, including
a desirable image.
- Marshall School of Business, University of Southern California. The author gratefully acknowledges
the helpful comments of Gregory Gundlach, David Soberman, and especially Philip B. Nelson.
1. 100 Leading National Advertisers, ADVERTISING AGE, June 25, 2007.
2. Based on nominal gross domestic product of $13.25 trillion for 2006. See Press Release, Bureau of
Economic Analysis, United States Department of Commerce (June 28, 2007).
Anthony J. Dukes, Advertising and Competition, in ISSUES IN
COMPETITION LAW AND POLICY 515 (ABA Section of Antitrust Law
2008)
516 ISSUES IN COMPETITION LAW AND POLICY
Because advertisers themselves decide on the content of advertisements, consumers
take information that is provided through advertisements with a grain of salt. As a
result, economists have sought to determine how consumers interpret advertisements
and to evaluate how they are affected by advertising. Illustrative questions that
economists have considered include: Does the mere fact that a product is advertised
signal to consumers that the product is a quality product? Does exposure to advertising
make consumers more or less price elastic? Can advertising ever be used to confuse
consumers?
By answering these types of questions, economists have developed an understanding
of how advertising works that provides insights into various public policies, including
antitrust law. In particular, because advertising can inform customers about market
prices, agreements that restrict advertising can have significant anticompetitive effects
on price by reducing the elasticity of demand that individual firms face. Because
advertising sometimes is an efficient source of information about product quality,
advertising can facilitate entry by allowing entrants to more quickly inform customers
about their new products, allowing the entrants to avoid the slower and more costly
experience-based diffusion of quality information. On the other hand, intensive
advertising may indicate that entrants must invest significant sums in advertising before
they can compete successfully in a market, implying that the market maybe insulated by
sunk cost barriers to entry.
This chapter reviews the economics literature that has analyzed advertising as well as
its relationship to competition,
3
providing a foundation for the analysis of the antitrust
issues that relate to advertising. Specifically, Section 2 elaborates on the role of
advertising in different market contexts. Section 3 discusses the economic incentives of
the individual firm with respect to its advertising decisions. Section 4 delves into the
strategic and competitive use of advertising. In particular, it analyzes how the
advertising of one firm may interact with the advertising of another firm and how
advertising may be used to differentiate a firms product so that the product is somewhat
insulated fromrivals pricing. The section also discusses the state of empirical findings
with respect to advertising and competition.
Finally, Section 5 turns the inquiry toward the social impact of advertising. In
particular, this section explores the social benefits and costsnet social welfareof
advertising, and how they align with those of the firm. This permits us to identify
sources of market failure in the provision of advertising.
2. The roles of advertising
The definition of advertising employed in this chapter stems from the economics
literature. Agreat deal has been written on advertising, however, outside of economics,
most notably in marketing, psychology, and business management; definitions across
disciplines may vary. Prominent marketing texts, for example, that of Kotler and
Armstrong,
4
classify advertising under the more general business activity of promotion
3. For a broader review of the advertising literature, see Kyle Bagwell, The Economic Analysis of
Advertising, in 3 HANDBOOK OF INDUSTRIAL ORG. (Mark Armstrong & Robert Porter eds., 2007).
4. PHILIP KOTLER & GARY ARMSTRONG, PRINCIPLES OF MARKETING (12th ed. 2007).
ADVERTISING AND COMPETITION 517
or marketing communication. The definition adopted here is that advertising is a costly
activity undertaken by the seller of a product and has an effect on the demand for that
product. The exact nature of this effect, however, has been the subject of discussion
among economists and is addressed in this section.
2.1. Classical roles
Economists typically viewadvertising as an activity that sellers undertake to inform
buyers about their products or persuade themthat a product is most suitable. The value
of advertising and the type of advertising that sellers undertake is likely to be
determined, at least in part, by characteristics of the products that they are selling. In
particular, in their analysis of advertising, economists distinguish four types of products:
search goods, experience goods, credence goods, and conspicuous goods.
Search goods are products that consumers can fully evaluate before they purchase
them. For example, a consumer can inspect a shirt (for quality, fit, etc.) and accurately
anticipate its net benefit before buying. Economists refer to such products as search
goods because a consumer search is sufficient by itself to make an informed purchase
decision. For search goods, advertising is used to lower the consumers search cost by
informing the consumer about the products existence, helping the consumer locate
where it is available, identifying the price that must be paid at different locations, and
identifying product characteristics that vary across product offerings.
Economists have recognized that there are some products for which the consumption
benefits are not known until after purchase and trial and refer to these products as
experience goods. Economists sometimes distinguish between two types of experience
goods: convenience goods and shopping goods. Convenience goods are products for
which consumers cannot be sure of the quality until they consume it, but because the
product is low priced and purchased on a frequent basis, consumers are able to use
information from past purchases to make informed choices. Beverages are a good
example of this type of product. Because repeat business is important to suppliers of
convenience goods, suppliers have an incentive to provide stable quality levels so that
the consumers experience the same level of quality across their purchases. Given these
product characteristics, low-priced sampling of products is a cost-effective learning
strategy for convenience goods. Because suppliers want to encourage customers to
include their product in the sampling, they have an incentive to advertise to gain trial of
their product. The accuracy of claims made in these advertisements is subject to
repeated checks by consumers, which may lead consumers to become confident in the
accuracy of claims made by particular brands and thus more willing to try new
products introduced by those brands.
5
Moreover, with respect to an individual
convenience good, the stability of the product and the information provided byhistorical
5. While the information theory described in the text is central to much advertising literature, the reader
should be aware that there is some contradictory empirical evidence. For example, high prices have
sometimes been found to be associated with lower quality levels for convenience goods. See Peter
Riesz, Price-Quality Correlations for Packaged Food Products, 13 J. CONSUMER AFF. 236 (1979);
Alfred Oxenfeldt, Consumer Knowledge: Its Measurement and Extent, 32 REV. ECON. & STAT. 300
(1950).
518 ISSUES IN COMPETITION LAW AND POLICY
trial may move the particular brand from having the characteristics of an experience
good towards having the characteristics of a search good and may force retailers who
resell these products to be careful about howthey price themsince comparison shopping
can be done relatively easily.
In contrast, shopping goods are high-priced goods that are purchased on an
infrequent basis. Automobiles are a good example of a shopping good. Because
sampling is not a cost-effective way for consumers to learn about these products,
economists have concluded that, in a comparative sense, consumers will make greater
use of the information and signals contained in advertising when buying shopping goods
than when buying convenience goods.
6
However, because the detailed information that
consumers often demand before buying shopping goods can sometimes be provided
more cost effectively in other ways, such as through point-of-sale instruction by a
salesman, advertising levels are not always as high for these goods as one might expect,
which may explain why Porter found that that the average outlayas a percentage of sales
was 4.7 percent for 19 convenience goods industries and only 2.1 percent for 23
shopping goods industries.
7
Another category of goods are credence goods. The qualityof these goods cannot be
fully assessed through trial, often because the utility of consuming these goods depends
in part on third-party reactions that are not easily assessed by the purchaser. For
example, suppose a bar patron buys a certain brand of beer to impress friends of his
refined taste in malt beverages. Beyond the enjoyment of the beer itself, added benefit
accrues to the purchaser because of what he believes others think of him. But since he
may never knowhowmuch his fellowbar-goers are impressed, he cannot be sure of the
benefit of the product even after consumption. For these goods, advertising maybe used
to reinforce the notion that a product will provide high levels of utility. In the beer case,
for instance, brand advertising conveys positive associations of those who drink the
beer. These associations are communicated, not only to the consumer, but also to his
friends.
The utility of consuming conspicuous goods, like credence goods, depends in part on
third parties reactions because these goods not only satisfy material needs but also
social needs such as prestige. Conspicuous goods include things such as jewelry,
perfumes, and watches that obtain some of their value fromthe prestige that individuals
get when others recognize that the individual is consuming exclusive goods.
8
In fact,
unlike typical products, the demand for conspicuous goods may rise with price.
9
Not only are there different types of products, there are different types of advertising.
Classical treatments of advertising sometimes distinguish three types of advertising:
informative, persuasive, and complementary.
6. See David N. Laband, Advertising as Information: An Empirical Note, 68 REV. ECON. & STAT. 517
(1986).
7. Michael Porter, Consumer Behavior Retailer Power and Market Performance in Consumer Goods
Industries, 56 REV. ECON. & STAT. 419 (1974).
8. Wilfred Amaldoss & Sanjay Jain, Pricing of Conspicuous Goods: A Competitive Analysis of Social
Effects, 42 J. MARKETING RES. 32 (2005).
9. Id.
ADVERTISING AND COMPETITION 519
Informative advertising is advertising that firms undertake to communicate product
information to the consumer. This information enables the consumer to evaluate the
utility he will obtain from buying the product. A magazine advertisement might, for
example, show pictures of the product, describe its features, and inform upon how or
where to purchase it. To be fully informative, it must also indicate the price of the
product. Grocery or department store mailers that announce sales and special product
offers are prototypical examples of informative advertising.
The lack of hard information on a typical television commercial, however, suggests
that the advertising often does not involve the direct provision of detailed information
about a product. Classical treatments of advertising explain this observation by
suggesting that advertising also has a persuasive role. Specifically, advertisers use
advertising to communicate messages designed to raise the consumers willingness to
pay for their product. It is in this sense that advertising persuades a potential buyer that
there is greater benefit from the product than he previously believed.
A key difference between these two roles is that, with informative advertising, a
consumers knowledge of the product (existence, price, where to buy, etc.) is updated
upon seeing the advertisement, while the consumers fundamental preferences remain
unchanged. In contrast, a persuasive advertisement affects a consumers preference for
the product.
Complementary advertising involves the related notion that advertising provides an
image that complements the physical characteristics of the product.
10
For instance,
consider a television commercial that shows a famous basketball player wearing a
particular brand of footwear. Such an advertisement might give a teenager a chance to
enjoy an association with the famous player when wearing the shoes. The teenager then
accrues an added benefit from this association beyond any inherent quality
characteristics of the shoe itself. The seller may accordingly charge a premium for the
product in order to capture this added value.
Closely related to complementary advertising is its ability to facilitate social
interactions within consumer segments. To illustrate, suppose a man smokes, and he
wants to smoke what other men smoke. Perhaps even more, he would rather not smoke
something that women smoke. If there are several brands of cigarettes and men do not
knowwhat their peers are smoking, then they will make a guess among existing brands.
If, on the other hand, a cigarette brand Y designs and airs advertising that appeals only
to men, then men conclude that brand Y is for them. In addition, although women also
see this ad, women do not buy brand Y, and men know this. Hence all men coordinate
on the right brand. This coordination role of advertising was first noted by Chwe
11
and, while it is a compelling explanation for the prominence of advertising for
conspicuously consumed products, it has not yet received a great deal of attention by
economists.
10. See Gary S. Becker &Kevin M. Murphy, A Simple Theory of Advertising as a Good or Bad, 108 Q. J.
ECON. 924 (1993).
11. Michael Chwe, Believe the Hype: Solving Coordination Problems with Television Advertising
(University of Chicago Department of Economics, Working Paper, 1998).
520 ISSUES IN COMPETITION LAW AND POLICY
Given the different types of advertising and the different types of products, it is not
surprising that different products are associated with different levels and types of
advertising. For example, products that are pure search goods, such as homogeneous
products that are easily graded (such as crude oil), are observed to have much lower
levels of advertising than experience goods.
12
While it remains to be fully tested,
products for which the persons utility depends on others tastes may be subject to more
image advertising than experience goods or search goods for which there is repeat
purchasing and only the purchasers utility is at issue. However, these types of
generalities may not hold in particular circumstances because firms can convey
information and brand image to consumers using other forms of promotion, such as sales
support, product packaging, and trial sampling. Moreover, because consumers have
diverse preferences, different advertising and promotional strategies may be used to
target distinct types of consumers.
2.2. Advertising as a signal
While advertising may involve the straightforward provision of information that
underlies the notions of informative, persuasive, and complementary advertising, some
economists have explored the possibility that advertising may provide consumers with
valuable information beyond its explicit content by providing consumers with a signal
about the quality of the product. According to this part of the economics literature, the
level of advertisingnot the content of the advertisingsignals consumers that a
particular product is of a particular quality. Specifically, when it is more beneficial for
high-quality sellers to advertise than low-quality sellers, firms that supply high-quality
products are expected to undertake more advertising and thus advertising intensity can
signal product quality. However, economists have come to recognize that the accuracy
of the signal depends on the market context.
13
The roles defined above are a useful
starting point to analyze the antitrust aspects of advertising. It is possible, however, to
extend these roles on more microeconomic foundations. In this section, I consider one
more viewto give a broader perspective: the signaling role of advertising. Because the
remainder of the chapter does not rely on this section, it can be skipped without loss of
continuity.
The persuasive role of advertising assumes that consumer preferences are subject to
change and that affected consumers are unable to detect the persuasive intention of the
advertising firm. Such an assumption might be difficult to maintain if consumers are
rational. Any seller of an experience good, for instance, may claim that its product is
high quality, regardless of the true quality level. A rational consumer then should
consider all persuasive messages meaningless.
I offer an explanation of how persuasive advertising can credibly communicate a
products quality to a rational consumer. Nelson was the first to suggest the signaling
role of advertising.
14
To illustrate his argument, consider the case when sellers of an
12. DOUGLAS F. GREER, INDUSTRIAL ORGANIZATION AND PUBLIC POLICY 127-29 (1992).
13. JEAN TIROLE, THE THEORY OF INDUSTRIAL ORGANIZATION 116-26 (1994).
14. Phillip Nelson, Advertising as Information, 82 J. POL. ECON. 729 (1974). For formal extensions of
Nelsons idea, see Paul Milgrom&John Roberts, Price and Advertising Signals of Quality, 94 J. POL.
ADVERTISING AND COMPETITION 521
experience good cannot make credible claims about high quality; a low-quality seller
loses little by claiming its quality is high. Aseller of high-quality experience goods can,
however, signal its quality by spending a sufficient amount on advertising. Suppose
consumers become repeat customers only if they enjoy high quality upon the first trial.
Due to repeat sales, the high-quality seller has more potential profit than a low-quality
imitator. In order to credibly convince the consumer it is high quality, the seller can
publicly spend off or burn some of these future profits by advertising to such an extent
that a low-quality producer would find it unprofitable to imitate. The rational consumer
observes this seller spending lots of money on advertising and concludes that it is
offering a high-quality product. It is worthwhile to note that the advertising message
itself is irrelevant beyond the cost to provide it. As long as consumers knowhowmuch
money was burned. Hence, a widely publicized charitable donation can also be a
credible signal in the same way as a costly advertising campaign.
The signaling theory offers an alternative to the persuasive advertising theory when
trying to explain why one observes certain types of persuasive advertising that contains
little direct information. To the extent high levels of advertising signal higher quality,
the mere act of advertising conveys reliable quality information to consumers and thus is
consistent with the observation that famous brands of cars, dish detergent, and other
goods with experience attributes are heavily advertised on television and contain little
hard information other than look how much money Im spending on advertising.
One still has difficulty using the signaling argument to explain all forms of
persuasive advertising. Productsfor example, popular brands of cola and beerhave
long been in existence, and it is likely that most people have experienced themat some
point or another. The signaling story, therefore, is an unlikely role for the ubiquitous
advertising for these popular brands given that most people have tasted them and
evaluated their true quality. As a result, the signaling role of advertising has been more
commonly attributed to new product launches.
15
The quality signaling role of advertising has received some, but limited, empirical
support. The strongest support comes from experimental marketing studies.
16
Caves
and Greene, on the other hand, find few correlations between advertising outlays and
Consumer Reports ratings of quality.
17
3. The firms advertising decision
Advertising is a business activity firms presumably choose to improve their profits
through its effect on consumer demand. Specifically, the information provided by
advertising may increase sales volume and permit price increases, both of which will
benefit firms in the formof increased revenues. However, advertising is a costlyactivity
ECON. 796 (1986); Richard Kihlstrom& Michael Riordan, Advertising as a Signal, 92 J. POL. ECON.
427 (1984); and Benjamin Klein & Keith B. Leffer, The Role of Market Forces in Assuring
Contractual Performance, 89 J. POL. ECON. 615 (1981).
15. See Milgrom & Roberts, supra note 14.
16. Amna Kirmani, The Effect of Perceived Advertising Costs on Brand Perceptions, 17 J. CONSUMER
RES. 160 (1990).
17. Richard Caves & David Greene, Brands Quality Levels, Prices and Advertising Outlays: Empirical
Evidence on Signals and Information Costs, 14 INTL J. INDUS. ORG. 29 (1996).
522 ISSUES IN COMPETITION LAW AND POLICY
and, as a result, choosing the optimal amount of advertising requires balancing its costs
and benefits. Economists have developed a useful framework for assessing the trade-off
between advertisings costs and benefits. I explore this framework belowin a classical
model set forth by Dorfman and Steiner.
18
The model allows us to focus on the firms incentive to advertise with respect to
demand conditions and its pricing decision. The firm faces a demand function,
( , ) q D p A = , which reflects the quantity demanded as function of price, p , and its
spending A on advertising. I assume
2 2
/ 0 / D p D p c c < < c c to reflect a downward
sloping (and convex) demand curve and
2 2
/ 0 / D A D A c c > > c c to reflect the notion that
advertising increases demand for the product at a decreasing rate. Note that our
reduced-form specification of demand permits us to be agnostic with respect to the
views of advertising discussed above. What is important is that advertising simply
affects market demand, and I do not account for its specific impact on consumer
information or preferences.
The firm chooses p and A in order to maximize its profits:
( , ) ( ) ( , ) p A p c D p A A t = (1)
where 0 c > denotes the marginal cost of the product. Under our assumptions, the
following two first-order conditions define the optimal decision of the firm:
( , ) ( , )
( , ) ( ) 0
p A D p A
D p A p c
p p
t c c
= + =
c c
(2)
( , ) ( , )
( ) 1 0
p A D p A
p c
A A
t c c
= =
c c
(3)
These equations depict the optimizing condition of equating marginal revenue to
marginal cost with respect to price and advertising, respectively. By manipulating the
equations, I can interpret them differently. For example, define the price elasticity of
demand as ( / )( / )
p
p q D p c c c , multiply Equation (2) by
p
q c , and rearrange to get
1
p
p c
p c

= (4)
This states that the optimal relative price margin, or percent contribution margin, is
inversely related to the value of price elasticity. Consistent with intuition, inelastic price
elasticity leads the firm to set high margins.
Now consider the advertising choice. First note that we can define the advertising
elasticity of demand as ( / )( / )
A
A q D A c c c , which states the percent increase in sales
for a 1 percent increase in advertising. Multiply Equation (3) by /
A
q p c , substitute in
Equation (4), and rearrange to get
18. Robert Dorfman & Peter O. Steiner, Optimal Advertising and Optimal Quality, 44 AM. ECON. REV.
826 (1952).
ADVERTISING AND COMPETITION 523
A
p
A
pq
c
c
=

(5)
Expressed this way, Equation (5), known as the Dorfman-Steiner equation, has a
convenient interpretation. At the optimump and A, the advertising to sales ratio is equal
to the ratio of advertising elasticity to price elasticity. This suggests that the firm will
advertise more whenever demand is very responsive to advertising (i.e., high
A
c ). This
helps to explain, for example, why there is interest frombrand advertisers to advertise to
children and young adults, whose preferences are highly malleable and influenced by
advertising. Conditions in the commercial media industry (e.g., television or radio) can
conceivably affect this advertising effectiveness as well.
19
Equation (5) further holds that the firm will advertise more if demand is relatively
price-insensitive (low | |
p
c ). Intuitively, a firm facing a less elastic demand obtains
higher margins fromeach additional consumer. This gives the firma bigger incentive to
use advertising to generate new customers. Given that automobiles had contributions
margins over 15 to 20 percent in the latter part of the twentieth century,
20
Equation (5)
appears consistent with the observation that the Big 3 domestic automakers were
among the top ten advertisers in the United States during that time.
21
Note that I have not discussed how advertising may affect price elasticity
p
c . We
can relate advertisings effect on price elasticity to the two views on advertising, as
discussed in Section 2. If, under an informative role, advertising generates additional
consumers or makes them more aware of market prices, it would lead to higher
elasticities. Alternatively, under the persuasive view, consumers become more
committed to a particular brand, and as a result elasticity is lower.
Finally, note that factors affecting elasticities on the right-hand side of Equation (5)
affect optimal advertising and price jointly. For example, the state of the commercial
media industry, television or radio, could conceivably alter a firms ability to
communicate with the market and thereby elasticity of advertising
A
c , therebyaffecting
the optimal choice. To illustrate, suppose that a new health study reveals enormous
benefits for ingredients found in some breads. If this has a decreasing effect on the price
elasticity for certain breads, then Equation (4) predicts an increase in the margin for
bread and Equation (5) predicts increases in advertising as well. Makers of the healthful
bread, seeing higher marginal benefits from sales, use advertising to generate them.
The central lesson fromthis analysis is that a firms advertising decision involves a
trade-off and, more importantly, this trade-off can very well depend on other factors
under the firms control, most notably price. This fact has important empirical
implications, especially when looking to the data for causal relationships between
advertising and price. This issue arises in Sections 4.3 and 4.4.
19. See Anthony Dukes, Media Concentration and Consumer Product Prices, 44 ECON. INQUIRY 128
(2006).
20. See F.M. SCHERER, INDUSTRY, STRUCTURE, STRATEGY, AND PUBLIC POLICY ch. 8 (1996); Steven
Berry, James Levinsohn &Ariel Pakes, Automobile Prices in Market Equilibrium, 60 ECONOMETRICA
889 (1995).
21. 100 Leading National Advertisers, ADVERTISING AGE, June 25, 2007.
524 ISSUES IN COMPETITION LAW AND POLICY
The preceding model involves a number of simplifying assumptions that affect the
results. For example, it assumes away any strategic interactions among two or more
advertising firms. I address this specifically in the next section. The preceding analysis
also ignored the possibility that advertising may have lagged effects, which would affect
the calculation of the revenue effects.
22
For example, the incentive tomorrow depends
on the durability of yesterdays advertising. This issue has implications for antitrust
when evaluating the extent to which there is long-run advertising capital that serves as
a barrier to entry. This issue is discussed later in Section 4.4.
4. Advertising and competition
The Dorfman-Steiner analysis of advertising behavior is not well-suited for
providing insights into the strategic interplay between competing firms. As such, the
model does not showhowfirms vary their advertising and prices in response to changes
in other firms advertising. I now turn to a discussion of strategic interactions between
firms. One model considers the interaction of firms advertising strategies and why
firms might want to achieve a consensus to reduce advertising. Asecond model focuses
on using advertising to differentiate a firms product so that rivals products are viewed
as more distant substitutes.
4.1. Interaction of competitive advertising strategies
In the previous analysis, it is appropriate to think of advertising as a way that a firm
can increase market demand. However, when a firm faces competition from existing
rivals or potential entrants, it will recognize that advertising may not only increase
general market demand but also increase the demand for the advertisers product at the
expense of its competitors. I will consider two models that recognize both the ability to
divert customers from rivals and the fact that firms will realize that rivals will react to
changes in advertising strategy.
To illustrate the economic incentives that are related to advertising that diverts sales
from competitors, I start with a simple game played by two firms. Assume that these
firms face a total market of 1,000 consumers. Either firm can choose one of two
strategies: to advertise or not to advertise. Without advertising, firms split the market
and each obtain 500 customers. If firms face marginal cost of $1 and their optimal price
is 2 $ = p , then they each earn profits of $500, less fixed costs, which we can ignore.
Now suppose that a firm can invest $100 in advertising to obtain 250 additional
customers. If one firmadvertises and the other does not, then the advertising firmearns
revenue of $750 ( $1 750 ) less advertising cost for a profit of $650. The
nonadvertising firm is left with 250 customers and a profit of $250. If, however, the
other firm also decides to advertise, then it gets 250 additional customers, neutralizing
the original loss of 250, and the market is again equally split. In this case, both firms
earn $500 less advertising costs, for a total of $400. Using these calculations, this
advertising game can be represented by the matrix in Figure 1. Note that each firmhas a
22. Marc Nerlove & Kenneth Arrow, Optimal Advertising Policy under Dynamic Considerations, 29
ECONOMICA 129 (1962).
ADVERTISING AND COMPETITION 525
strategic incentive to advertise. No matter what Firm 2 does, it is best for Firm 1 to
advertise; similarly for Firm 2. This leads to an equilibrium in which both firms
advertise. The unfortunate consequence for both firms is that they are worse off than if
they both did not advertise. Thus, the ability to advertise can create a prisoners
dilemma in industries where advertising is effective for business stealing.
Note that I assumed that prices stay constant before and after advertising. The
prisoners dilemma becomes even more pronounced if advertising leads to lower prices.
One might anticipate this situation whenever consumers view products as relatively
undifferentiated but have imperfect information about competing prices. If search costs
are nontrivial, uninformed consumers may stop at the first seller they find. Knowing
this, the seller can then charge higher than competitive prices. Without advertising,
therefore, each participating firmcan enjoy a set of loyalhigh-payingcustomers. If
price advertising is possible, however, a firmcould easily acquire a big jump in revenue
by targeting a rivals loyal customers and advertising a slightly lower price. If all firms
adopted this strategy, one would expect prices and profits to fall. That is, the payoffs in
the equilibrium outcome (Advertise, Advertise) would be even lower than $400.
The discussion above points to a potential benefit to firms if they could somehow
commit themselves to not advertise. One way that firms might try to reduce competitive
advertising is to use a common marketing agency to control the level of advertising.
Another way is to induce regulated limits on advertising as has been done for
professional services such as lawyers and doctors. Another possibility, which occurs in
markets where advertising strategy in one period may depend on what happened in
earlier periods (which are modeled as repeated games), is to undertake disciplinary
advertising levels whenever rivals cheat by doing more advertising than was agreed
(possibly implicitly) upon.
4.2. Use of advertising to differentiate products
Competitive incentives to advertise need not always lead to business stealing
problems for firms. In some cases, advertising can serve to differentiate products so that
consumers view the products as more distant competitors, reducing the cross-elasticity
of demand between the products. Such a situation may arise under the complementary
role of advertising discussed above. Recall that under this role, it is advertising images
that are sold along with the product. As a result, competing firms can choose images
that appeal to segments of the market to insulate their product to some extent from the
526 ISSUES IN COMPETITION LAW AND POLICY
pricing of potentially substitutable products, perhaps even creating a separate relevant
product market.
23
To illustrate the economic incentives to undertake this type of strategy, consider the
following advertising game played by two firms: Both firms sell colas that are otherwise
similar in taste. A set of 1,000 consumers are fully familiar with the two brands. If the
firms do not advertise, they split the market at the competitive price of $2. Given a
marginal cost of $1, each firm obtains $500 profit. Suppose that consumers can be
divided into two groups: young and old. Further suppose that Firm 1 can appeal to
young people through its advertising images at a cost of $100. If this segment becomes
more loyal, Firm 1 can raise its price from $2 to $3, giving profit of $900
( $(3 1) 500 100 ). What is the consequence to Firm2? Given that Firm1 has raised
its price, the residual demand facing Firm2 is less elastic. Firm2 can then raise its price
to $2.50 even though it does not advertise. Its profit in this case is $750
( $(2.5 1) 500 ). Nowsuppose that Firm2 decides to advertise. Then the price effect
is doubled because of its effect on Firm 1s demand. Consequently, when both firms
advertise, prices go up to $4, leading to profits of $1,400. Clearly, the outcome with
both firms advertising is the equilibriumof this game (summarized in Figure 2) and, in
contrast to the previous situation, makes firms better off than with no advertising.
The preceding discussion illustrates theoreticallyhowpersuasive advertising can be a
means to relax price competition. Section 4.1, in contrast, illustrated the opposite
outcome for informative advertisingnamely, that advertising could facilitate lower
prices. While these results point in opposite directions with respect to competitive
outcomes, it is important to bear in mind that they are not contradictory. Rather, they
illustrate the need for caution when applying a uniform role for advertising for the
purposes of assessing its impact on competition.
24
4.3. Advertising and competitive outcomes: empirical findings
Based on our theoretical discussions above, some questions emerge. First, does there
exist a causal relationship between advertising and competitive market outcomes? In
23. The antitrust authorities sometimes recognize narrow product markets that are based on product
differentiation. For example, the antitrust agencies have found a separate superpremiumice cream
market. See Complaint at IV, Nestle Holdings, Inc., FTC Dkt. No. c-4082 (June 25, 2003).
24. For accessible and illustrative examples of howand when differentiation is facilitated by advertising,
see David A. Soberman, The Role of Differentiation in Markets Driven by Advertising, 45 CAL.
MGMT. REV. 130 (2003).
ADVERTISING AND COMPETITION 527
answering this question, economists have focused on the relationship between
advertising and prices. Specifically, this research attempts to determine whether firms
ability to advertise causes higher or lower prices. In this section, I examine the current
state of empirical research on advertising and prices. Unfortunately, it does not take us
far. The problem is either that much of the data is too specialized or that the studies
suffer from methodological difficulties inherent in advertising research. That is not to
say one has nothing to learn fromthe body of empirical findings. However, one should
avoid overgeneralizing their results.
Though early studies have found a positive link between advertising and product
prices,
25
one cannot be certain that advertising caused higher prices. Recall from our
analysis in Section 3 that high margins induce the firm to advertise more since its
benefits are greater than with lowmargins. This means that the reverse or neutral case is
also plausible. That is, we cannot rule out the possibility that high prices cause more
advertising, or that some common underlying demand process is driving both high
prices and high advertising.
Therefore, at best, we can offer the following empirical test: if advertising facilitates
competition, then it should cause prices to fall. However, establishing causalityis not
simple and cannot be done adequately froma simple cross-section of industryprices and
advertising spending. Some studies have circumvented this causality problem by
exploiting natural experiments by which some external process (such as a legal
restriction) prevented advertising in some geographical region or during some period in
time. Benham, for example, showed that the price of eyeglasses was higher in states
where optometrists were forbidden to engage in price advertising.
26
Similarly, Glazer
examined prices of several grocery items before, during, and after the 1978 newspaper
strike in New York City.
27
He found that prices were higher during the strike when
stores could not communicate prices to consumers through newspaper ads. And, more
recently, Milyo and Waldfogel examined the impact of the removal of a Rhode Island
ban on liquor stores that advertised the price of alcoholic beverages.
28
They found that
prices fell after the ban was removed by the Supreme Court in 1996.
These studies support the view that price advertising leads to more competitive
outcomes. Because price advertising informs consumers of available prices, sellers must
compete more aggressively on price. One must bear in mind, however, that these
studies had a specific feature in common: they all involved price advertising among
retailers who carried similar product assortments. This is a consistent fit with the
informative role discussed in Section 2 and one should avoid generalizing this regularity
to other forms of nonprice advertising.
For the case of nonprice advertising, there is some experimental evidence that it
reduces consumers price sensitivity and, thus, may lead to higher prices. For example,
25. See F.M. SCHERER & D. ROSS, INDUSTRIAL MARKET STRUCTURE AND ECONOMIC PERFORMANCE
(1990); Lester Telser, Advertising and Competition, 72 J. POL. ECON. 573 (1964).
26. Lee Benham, The Effect of Advertising on the Price of Eyeglasses, 15 J.L. & ECON. 337 (1972).
27. Amihai Glazer, Advertising, Information, and PricesA Case Study, 19 ECON. INQUIRY661 (1981).
28. Jeremy Milyo & Joel Waldfolgel, The Effect of Price Advertising on Prices: Evidence in the Wake of
44 Liquormart, 89 AM. ECON. REV. 1081 (1999).
528 ISSUES IN COMPETITION LAW AND POLICY
Krishnamurthi and Raj studied a split-cable television experiment in which consumer
panels were shown differing amounts of advertising.
29
The main finding was that
nonprice advertising for a well-established brand decreased consumers price sensitivity.
Under the persuasive role, this sort of advertising helps the firmposition its product by
differentiating it vis--vis competing brands. A behavioral interpretation is that the
advertisements nonprice content distracts consumer attention awayfromprice.
30
Given
this result, it is important to bear in mind that even if nonprice advertising leads to
higher prices, it does not automatically imply a reduction in consumer welfare. In
particular, nonprice content may, in fact, enhance the consumers value of the product
under the complementary view of advertising.
In addition to the controlled experimental studies, there is one additional studyworth
noting from the cigarette industry. Cigarette advertising on television, arguably
considered as nonprice advertising, was banned in the United States in 1970. Eckard
used this ban as a natural experiment on the competitive aspect of nonprice
advertising.
31
In contrast to the above experimental studies, his analysis found that the
price-cost margins of major cigarette firms were higher after the television commercial
ban.
In sum, the empirical results on advertising and competition are tenuous.
Nevertheless, there is evidence suggesting that the ability of firms to use informative
price advertising leads to more competitive outcomes. There is also evidence that
noninformative advertising may lower consumers price sensitivity, but its general effect
on competition is ambiguous.
4.4. Advertising, concentration, and barriers to entry
Economists have long theorized about the possibility that advertising by incumbent
firms may create barriers to entry by potential rivals. One theory suggests that
advertising is a means to communicate or signal its ability to drive out potential
competitors should they enter.
32
Another theory states that if advertising has long-run
persuasive effects on consumers, then an incumbent can invest in advertising in order to
tighten its grip on consumers, thereby imposing additional costs on any potential
entrant.
33
The notion that advertising is an investment and may have a long-termeffect
on consumers is referred to as goodwill capital. The latter theory has received the
most attention by economists, especially with respect to finding empirical evidence
29. Laksman Krishanmurthi & S.P. Raj, The Effect of Advertising on Consumer Price Sensitivity, 22 J.
MARKETING RES. 119 (1985).
30. Anil Kaul &Dick R. Wittink, Empirical Generalizations about the Impact of Advertising onSensitivity
and Price, 14 MARKETING SCI. 151 (1995).
31. E. Woodrow Eckard, Jr., Competition and the Cigarette TV Advertising Ban, 29 ECON. INQUIRY 119
(1991).
32. Kyle Bagwell & Gerry Ramey, Advertising and Pricing to Deter or Accommodate Entry When
Demand is Unknown, 8 INTL J. INDUS. ORG. 93 (1990).
33. Richard Schmalensee, Product Differentiation Advantages of Pioneering Brands, 72 AM. ECON. REV.
349 (1982); Avinash Dixit & Victor Norman, Advertising and Welfare, 9 BELL J. ECON. 1 (1978).
ADVERTISING AND COMPETITION 529
supporting or refuting the use of advertising as a means to erect entry barriers.
34
In this
section, I review these empirical findings.
Many studies begin with the hypothesis that if advertising is a barrier to entry, then
one should observe in industries with heavy advertising either (1) higher firm
concentration, or (2) higher economic profits relative to industries with less advertising.
Using cross-sectional interindustry data, early studies found little, if any, linear
association between industry concentration measures and advertising intensity.
35
Later
studies, however, recognized that cross-sectional data might not reveal advertisings
goodwill effects which are built over time. Using 30 years of time-series data, Mueller
and Rogers observed an increase in the concentration measures in consumer goods
industries over the growth era of television advertising, i.e., from1947 to 1977.
36
While
this effect was not present for industrial goods, they found that television advertising
could explain a large portion of the change for consumer goods. It is not conclusive,
however, whether television advertising caused increases in market power over this
time.
The 1970 ban on the television advertising of cigarettes in the United States,
however, offered a natural experiment to test the hypothesis that advertising strengthens
market power, as measured by firmconcentration. Evidence fromseveral studies of this
event contradict this hypothesis.
37
In fact, Eckards analysis of cigarette industry data
before and after the ban suggests that the elimination of television advertising increased
industry concentration levels, which had been declining before the ban.
38
This analysis,
as well as that by Holak and Reddy, further indicates that the 1970 advertising ban
reduced brand switching.
39
All of this work suggests that there is little evidence of a linear and positive
association between advertising and industry concentration. A good bit of work has
been devoted to the possibility of a more complex, nonlinear association. Sutton, for
example, suggest an inverted U-shaped relationship in which advertising intensities are
positively associated with low degrees of concentration up to a point, after which there
is a negative association.
40
One possible reason attributed to a drop-off in advertising in
highly concentrated industries is based on the business stealing notion of competitive
advertising. If there are fewer firms, then it is easier for them to cooperate in a less
34. JOE BAIN, BARRIERS TO NEW COMPETITION: THE CHARACTER AND CONSEQUENCES IN
MANUFACTURING INDUSTRIES (1956).
35. See, most notably, WILLIAM COMANOR & THOMAS WILSON, ADVERTISING AND MARKET
STRUCTURE (1974); and Nicholas Kaldor, The Economic Aspects of Advertising, 18 REV. ECON. STUD.
1 (1950).
36. Willard F. Mueller & Richard T. Rogers, The Role of Advertising in Changing Concentration of
Manufacturing Industries, 62 REV. ECON. & STAT. 89 (1980).
37. See Eckard, supra note 31; Mark Mitchell & J. Harold Mulherin, Finessing the Political System: The
Cigarette Advertising Ban, 54 S. ECON. J. 855 (1988).
38. See Eckard, supra note 31.
39. Id.; Susan Holak &Srinivas Reddy, Effects of a Television and Radio Advertising Ban: A Study of the
Cigarette Industry, 50 J. MARKETING 219 (1986).
40. See JOHN SUTTON, SUNK COSTS AND MARKET STRUCTURE (1991); John Sutton, Advertising,
Concentration, and Competition, 84 ECON. J. 56 (1974).
530 ISSUES IN COMPETITION LAW AND POLICY
competitive advertising environment.
41
The overall body of evidence of the inverted U-
shaped relationship is mixed, however.
42
What about the relationship between advertising and industry profit levels? Some
empirical support for this may be found in the industry cross-sectional analysis of
Comanor and Wilson,
43
which finds a significant and positive correlation between
accounting profit rates and advertising to sales ratios. One important challenge to this
analysis is whether the reported accounting profit rate is an unbiased measure of the true
profit rate. In particular, it has been shown that the accounting profit rate may overstate
the true profit rate when advertising expenditures are inappropriately depreciated as
capital investments.
44
As noted by Weiss, one may consider advertising spending as
long-term investments in goodwill, an intangible notion of capital that exists in the
form of long-term brand loyalty.
45
Ayanian takes this notion further and suggests that
the rate at which goodwill capital decays, or depreciates, has dire implications for the
relationship between incumbent profitability and advertising intensities.
46
Using
advertising and accounting profit data from 39 firms over ten years, he estimates the
depreciation rate of advertising and reevaluates the relationship between firms
accounting profits and advertising. His analysis indicates that when one accounts for the
decay of advertising goodwill, the positive association between profits and advertising
intensity disappears.
The analysis of Ayanian has, itself, been challenged and economists remain unsure
as to the true degree of bias in profit measures.
47
But even if one accepts Comanors and
Wilsons measure of profits,
48
their cross-sectional data does not foreclose the
possibility that profits and advertising are driven by the same, unobserved, process.
As with advertising and concentration, the 1970 ban on cigarette advertising offered
a natural experiment to assess causality of advertising and profits. The regressions of
Mitchell and Mulerin indicate a significant increase in the stock prices of cigarette
industry firms at the time of the ad ban.
49
They suggest that this increase reflects
investors beliefs of future profitability of the cigarette firms due to reduced
competition.
In general, the body of empirical research offers little convincing evidence
supporting the hypothesis that firms advertising intensity is positively related to
industry concentration ratios or profits. The implication is that there seems to be little
indirect evidence that there are barriers to entry in heavily advertised industries. Direct
41. See Douglas F. Greer, Advertising and Market Concentration, 38 S. ECON. J. 19 (1971).
42. See Bagwell, supra note 3.
43. See COMANOR & WILSON, supra note 35; William Comanor & Thomas Wilson, The Effect of
Advertising on Competition: A Survey, 17 J. ECON. LITERATURE 453 (1979).
44. Harold Demsetz, Accounting for Advertising as a Barrier to Entry, 52 J. BUS. 345 (1979).
45. Leonard Weiss, Advertising, Profits, and Corporate Taxes, 51 REV. ECON. & STAT. 421 (1994).
46. Robert Ayanian, Advertising and the Rate of Return, 18 J.L. & ECON. 479 (1975).
47. The nature of the debate revolves around estimating the depreciation rate of advertising goodwill,
which depends directly on the duration of advertisings long-run effects onconsumers. Clarks review
of the empirical research suggests a duration interval of three to 15 months. Darral Clark, Econometric
Measurement of the Duration of Advertising Effect on Sales, 13 J. MARKETING RES. 345 (1976).
48. See COMANOR & WILSON, supra note 35.
49. See Mitchell & Mulherin, supra note 37.
ADVERTISING AND COMPETITION 531
evidence, however, might be found by examining actual entry decisions bygeneric drug
manufacturers in the pharmaceutical industry. Scott-Morton examined 98 drugs that lost
patent protection between 1986 and 1992 and estimated the factors that affected entryby
generics.
50
She finds, in fact, that advertising may affect entry (either positively or
negatively) when advertising is treated exogenously. However, the problem with the
exogeneity assumption, she notes, is that if a market is sizable enough to enter, it is also
worth advertising in. By treating advertising as endogenous for the incumbent, she finds
the effects of advertising are insignificant for entrydecisions. She concludes that brand
advertising is not a barrier to entry in the United States pharmaceutical market.
51
While the empirical evidence from industry data does not support the notion that
advertising is a barrier to entry, some survey and managerial research supports it. For
example, according to surveys, product managers viewadvertising as a strategic tool to
prevent competitive entry.
52
In addition, there are reports of incumbent brands using
advertising copy intended to interfere with the advertisements of an entrant. Hilke and
Nelson document a federal antitrust case in which the producers of Maxwell House
brand coffee were accused of mimicking the advertising copy of new commercials by
the entering brand, Folgers.
53
Behavioral studies in marketing offer support for the
notion that the incumbent brand has the advantage over the entrant of being first in the
consumers memory when faced with similar but competing advertisements.
54
In conclusion, there is a good bit of evidence that advertising is viewed as a possible
means for an incumbent firm to thwart entry. However, evidence from actual industry
choice data that advertising actually prevents entry is slim.
5. Advertising and economic welfare
Economists have also explored whether there is too much or too little advertising
from the point of view of social welfare. At the simplest level, firms may have an
incentive to invest in advertising to differentiate their product so that their pricing is
insulated fromrival prices. This private incentive may not align with the social value of
the advertising, and, as a result, there may be too much advertising. On the other hand,
firms that advertise may provide socially valuable information that expands the overall
size of the product market, which will benefit rivals as well as themselves. Because an
advertiser may not capture all of the benefits of its advertising, advertisers maynot have
sufficient incentive to undertake as much advertising as is socially desirable. Given
these (or similar) conflicting economic forces, economists have struggled to determine
whether there is too much or too little advertising.
50. Fiona M. Scott-Morton, Barriers to Entry, Brand Advertising, and Generic Entry in the U.S.
Pharmaceutical Industry, 18 INTL J. INDUS. ORG. 1085 (2000).
51. Id. at 1103.
52. See David Bunch & Robert Smiley, Who Deters Entry? Evidence on the Use of Strategic Entry
Deterrents, 74 REV. ECON. & STAT. 509 (1992).
53. John C. Hilke &Philip B. Nelson, Noisy Advertising and the Predation Rule in Antitrust Analysis, 74
AM. ECON. REV. 367 (1984).
54. See Anand Kumar & Shanker Krishnan, Memory Interference in Advertising: A Replication and
Extension, 33 J. CONSUMER RES. 602 (2004); Raymond R. Burke & Thomas K. Skrull, Competitive
Interference and Consumer Memory for Advertising, 15 J. CONSUMER RES. 55 (1988).
532 ISSUES IN COMPETITION LAW AND POLICY
To better understand this debate, it is helpful to consider the welfare effects of
advertising in the simple monopoly advertising model discussed above in Section 3. To
start, we evaluate the case in which advertising is persuasive and leads to a market price
increase.
55
Let
0 0
( , ) D p A denote the demand curve at an initial level of advertising. As
before, the marginal cost of production is constant at 0 c > . Denote by
0
p the
monopolists optimal price, which leads to output
0 0 0 0
( , ) q D p A = , as depicted in
Figure 3. Initial welfare is the sumof consumer and producer surplus, which is the area
below the curve
0
D and above the marginal cost line from 0 to
0
q .
I now consider the change in welfare after a marginal increase in advertising to
1 0
A A A = + A . This increase in advertising shifts demand to
1 1
( , ) D p A . Recall that we
are assuming the monopolists optimal price increases due to advertising:
1 0
p p > .
Referring to Figure 3, we graphically assess the distribution of welfare change. The
total change in welfare W A due to the advertising increase is the area abde less the
additional cost of advertising A A . This is the additional surpluses (producer plus
consumer) from the added consumption facilitated by the advertising. This welfare
55. This analysis was originally contributed by Avinash Dixit and Victor Norman. See Dixit & Norman,
supra note 33.
ADVERTISING AND COMPETITION 533
change, gross A A , can be dissected in two parts, areas gbde and abg, where the latter is
only of second-order importance (on the same order as p q A A ). This can be neglected
for marginal changes in A (i.e., small A A ).
Also note that the additional profit to the monopolist, t A , is the area
o
bdefp p
1
less
the additional cost of advertising A A . This, and the above discussion, allows us to
(first-order) approximate the change in welfare as
0
W q p t A ~ A A (6)
Since an optimizing monopolist will set the marginal benefit of advertising equal to
its marginal cost, we have that 0 t A = , leaving 0 W A < since 0 p A > by assumption.
Note that the monopolists and the social planners incentives are aligned with
respect to costs, namely, A A . However, for the monopolist, the private benefit of
additional monopoly power exceeds the public benefit of additional consumption.
Hence, the monopolist chooses socially excessive persuasive advertising.
It can be shown that this result does not depend on the monopoly market structure
assumed here.
56
In particular, as long as the firmhas some degree of market power (i.e.,
under imperfect competition) it will employ socially excessive levels of persuasive
advertising.
It is possible, however, to challenge this result on the assumed role of advertising.
Recall that we measured welfare excluding the area between the demand curves
northwest of af (denoted Z) because these consumers would already have bought before
advertising. Measuring welfare in this way is appropriate only if the consumers
represented by the demand curve
1
D were in the market prior to advertising and thus
were previously represented by
0
D . If, however, we take a complementary role of
advertising by supposing that consumers enjoy the brand associations that complement
the actual product, then presumably all inframarginal consumers obtain added benefit
from advertising. Therefore, welfare calculations in Equation (6) should include the
area represented by area Z if advertising takes on a complementaryrole. This distinction
of advertisings role is crucial and challenges the result that advertising is socially
excessive. In particular, the size of area Z, depending on whether it is large or small
relative to
0
q p A , will determine whether W A is positive or negative. But determining
this area requires us to make strong assumptions about the upper tail of the demand. As
such, it is difficult to make decisive conclusions about the nature of market failure in the
case of complementary advertising.
The informative role poses another challenge to the excessive advertising result. To
see this, suppose that advertising increases demand byinforming a set of consumers who
would otherwise not be aware of the products existence. Then our measurement of the
welfare effects must consider the added distributional benefits of advertising.
57
To illustrate, reconsider the monopoly situation above and suppose that at state 0 a
set of n consumers are informed whose buying behavior is characterized by the demand
given
0 0
( , ) D p A . Further suppose that, by increasing advertising by 0 A A > , an
56. See Dixit & Norman, supra note 33.
57. This was first pointed out by Shapiro. See Carl Shapiro, Advertising and Welfare: Comment, 12 BELL
J. ECON. 749 (1980).
534 ISSUES IN COMPETITION LAW AND POLICY
additional set of people become informed. To make matters simple, suppose that these
newly informed consumers are identical to the original group of n consumers. Then, the
new demand is twice the original. That is,
1 0 0 0
( , ) 2 ( , ) D p A A D p A + A = , which
corresponds to a demand shift as illustrated in Figure 4. Since price elasticityof demand
remains constant under this assumed shift, we knowfromour analysis in Section 3 that
the monopolists optimal price remains at
0
p .
The welfare accounting fromthe previous case applies as before, except that nowwe
include the surplus accruing those new consumers who would not have otherwise
consumed before the advertising, which is measured by the area abd. Including this
surplus, our welfare expression from Equation (6) gives
0
W q p abd t A ~ A A + (7)
As before, if the monopolist is profit maximizing with respect to advertising, then
t A is zero. Therefore, since price is constant ( 0 p A = ), the second term is also zero.
Hence, the change in welfare is positive: 0 W abd A ~ > .
This implies that the monopolist advertises too little relative to the social optimum.
The additional benefit accruing to the newly informed consumers is not fully
appropriated by the advertising firm. The monopolists optimal advertising level,
ADVERTISING AND COMPETITION 535
therefore, is at a point where the marginal social benefit exceeds the marginal social
costs.
The reader might suspect that the simplifying assumption that 0 p A = restricts
generalizations of this result. But this is not the case. Even if the price were to increase
fromadvertising ( 0 p A > ), it is still possible for the net welfare change to be positive if
the surplus to newly informed consumers, as measured by area abd, is sufficiently high
relative to
0
q p A . If the optimal monopoly price falls after advertising, thereby
alleviating monopoly pricing distortions, then the marginal welfare gain is even greater
than area abd. Consequently, we have now a fairly general result: the monopolist
provides a socially insufficient level of informative advertising.
This market distortion occurs because the monopolist does not appropriate all the
additional social benefits accruing from informing new consumers. This would not be
the case, however, if the monopolist could price discriminate. For example, suppose the
monopolist had the ability to target its advertising messages. The monopolist, in
principle, could state different prices depending on who receives the advertisement. By
charging prices closer to consumers valuations, the monopolist internalizes more
benefits of advertising. Practical difficulties aside, as the monopolists ability to price
discriminate becomes more perfect, the above analysis implies that the optimallychosen
level of advertising would approach the socially optimal level.
In summary, the above analysis suggests that when advertising is purely persuasive,
it tends to be socially excessive. On the other hand, the market level of informative
advertising tends to fall short of the socially optimal level. Finally, ambiguity arises
when determining the nature of market failure whenever advertising is viewed as
complementary.
The insights fromour monopoly analysis can be extended to competitive settings by
noting that, in general, strategic incentives will tend to increase market levels of
advertising. For example, competition with informative advertising adds the business
stealing motivation for advertising.
58
Hence, compared to competitive situations, the
conclusions drawn from the monopoly analysis will tend to understate market level of
advertising relative to the socially optimal level.
Finally, it is important to point out that our analysis entirely neglected anysocial cost
associated with bothersome or obtrusive advertising. An advertisement, even if
informative, can impose a cost on the consumer not wishing to receive it. Unwelcome
spam and commercial interruptions during ones favorite television program are
examples of imposed nuisance costs on the recipient. And, because this cost is generally
not borne by the advertiser, market distortions arise.
6. Conclusion
This chapter serves as an introduction to the economic analysis of advertising and
competition. The intention is to provide an economic framework for evaluating the role
58. Grossman and Shapiro show that informative advertising in a competitive setting can be socially
excessive when the social cost of informing a consumer of an alternative product exceeds the
consumers gain of obtaining a lower price. See Gene Grossman & Carl Shapiro, Informative
Advertising with Differentiated Products, 51 REV. ECON. STUD. 63 (1984).
536 ISSUES IN COMPETITION LAW AND POLICY
of advertising with respect to market outcomes as well as for assessing the degree to
which social and firm incentives are aligned. The reader should keep in mind that the
analysis in this chapter leaves a lot of questions unanswered. While economic research
on advertising continues, the summary belowgives the main conclusions fromwhat has
been learned to date.
Economists have recognized that advertising is a complex process and that
attributing a one-size-fits-all approach can be misleading when assessing the
implications of advertising on competitive outcomes. For that reason, Section 2
described various roles advertising might take and the industry conditions or product
types for which each role is most appropriate. We also stressed that the typology of
advertising roles described here, while useful, is not exhaustive. Nor are the roles
exclusive; any given advertisement should not be seen as necessarily fulfilling exactly
one role.
Regardless of its role(s), we presume that advertising has positive effects on demand.
The amount of benefit to a firm, however, depends on how much it advertises, not to
mention a variety of consumer factors and the state of competition. Therefore, when
choosing an amount of advertising, the firm must balance this benefit with the cost of
advertising. Section 3 provided a framework that accounts for this economic trade-off.
An important, but simple, lesson from that analysis of this trade-off is that demand
factors, such as elasticity, may drive a firms choice of advertising levels and prices
simultaneously. This issue, as discussed in Section 4, has implications for assessing a
causal relationship between advertising intensity and price levels.
Section 4 illustrated how the role of advertising has profound, but opposing,
implications for how aggressively firms compete on prices. If advertisings role is
clearinformative or persuasivethen its theoretical impact on price competition is
also clear. However, as concluded fromSection 2, advertisings role maynot be so clear
in practice. Therefore, I turned to the body of empirical research for some more specific
answers. Some important conclusions emerged:
the ability of firms to use price advertising tends to lower product prices;
there exists limited evidence that nonprice advertising lowers price elasticity;
and
stronger conclusions from empirical studies are severely weakened by data
limitations.
Section 4 also explored the hypothesis that advertising creates barriers to competitive
entry, industry concentration, and above normal industry profits. The bodyof empirical
research offered the following broad conclusions:
there is little evidence that advertising causes firm concentration or that the
ability to advertise ensures above normal industry profits;
the empirical economic evidence that advertising creates barriers to entry is
weak;
behavioral evidence suggests that an incumbents brand is recalled from
memory more often than an entrants when advertising messages are similar;
and
ADVERTISING AND COMPETITION 537
business managers report in surveys that they view advertising as a potential
entry deterrent.
Finally, Section 5 analyzed the extent to which competitive market incentives align
with social incentives. The theory predicted purely persuasive advertising tends to be in
excess of the social optimum. However, this result becomes ambiguous under the
complementary role of advertising. Finally, informative advertising levels may fall
short of the social optimum. There is virtually no empirical research to help resolve
much of this theoretical ambiguity.