Chapter 28 The Economic Analysis of Advertising

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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 chapter begins with a discussion of the key initial writings that are associated with the persuasive, informative and complementary views of advertising. Next, work that characterizes empirical regularities between advertising and other variables is considered. Much of this work is conducted at the inter-industry level but important industry studies are also discussed. The chapter then offers several sections that summarize formal economic theories of advertising. In particular, respective sections are devoted to positive 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 provided of empirical work that evaluates the predictions of recent theories of advertising, including work that specifies and estimates explicitly structural models of firm and consumer 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 empirical 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 neuroeconomics is also featured. A final section offers some concluding thoughts.

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 billion 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 analysis 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 significant 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, however, could be achieved only if demand were appropriately stimulated. The turn-of-the-century technological innovations that are associated with mass production and 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 Marshall, 1890, Marshall, 1919, who offers some insightful distinctions, and then gathers momentum with Chamberlin'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 summarize 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; however, 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 innovation 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 inelastic, 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” 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 solution. When a firm advertises, consumers receive at low cost additional 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 facilitate entry, as it provides a means though which a new entrant can publicize its existence, prices and products. The suggestion here, then, is that advertising can have important pro-competitive effects.

A third view is that advertising is complementary to the advertised product. According 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 enters 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 information.

These views are all, at some level, plausible. But they have dramatically different positive and normative implications. The persuasive and informative views, in particular, offer conflicting assessments of the social value of advertising. It is of special importance, therefore, to subject these views to rigorous empirical and theoretical evaluation. 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 1970s. Over this period, a voluminous literature investigated general empirical relationships 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 regression analyses, particularly at the inter-industry level. While the inter-industry analyses are often inconclusive, defensible empirical patterns emerge within particular industries or narrow industry categories. The evidence strongly suggests that no single view of advertising is valid in all settings.

The empirical studies suggest important roles for advertising theory. First, theoretical work might make progress where empirical work has failed. A general theoretical argument might exist, for example, that indicates that advertising is always excessively supplied by the market. Likewise, a theoretical model might assess the validity of the persuasive-view hypothesis that advertising deters entry. Second, advances in the theory of advertising might generate new predictions as to the relationships between advertising and market structure. In turn, these predictions could motivate new empirical work. Third, and relatedly, theoretical work might provide a foundation from which to appropriately specify the supply side of more sophisticated econometric analyses, in which the endogeneity of consumer and firm conduct is embraced. Utilizing recent advances in game theory, economists thus began in the late 1970s to advance formal theories of advertising. This work is vital and ongoing.

Beginning in the 1980s, economists approached the empirical analyses of advertising with renewed interest. For the purposes of this survey, it is useful to organize the modern work in three broad groups. Studies in the first group often use new data sources and further evaluate the empirical findings of the earlier empirical work. These studies are not strongly influenced by the intervening theoretical work. Studies in the second group also draw on new data sets, sometimes constructed at the brand and even household levels, and reflect more strongly the influence of the intervening theoretical work. The conduct of firms and consumers in particular industries is emphasized. Studies in this group evaluate the predictions of strategic theories of advertising, and may even specify and estimate explicit structural models of consumer and firm conduct. Finally, following Sutton (1991), a third group of studies culls from the intervening theoretical work a few robust predictions that might apply across broad groups of industries. Studies in the third group thus sometimes return to the inter-industry focus that characterized much of the earlier empirical work; however, the empirical analysis is now strongly guided by general theoretical considerations.

This historical description provides a context in which to understand the organization of this survey. In Section 2, I describe the work of Marshall, 1890, Marshall, 1919 and Chamberlin (1933), and I review the key initial writings that are associated with each of the three views. This discussion is developed at some length, since these writings contain the central ideas that shape (and are often re-discovered by) the later literature. Section 3 contains a summary of the findings of the initial and modern (first-group) empirical efforts.4 In Sections 4 Monopoly advertising, 5 Advertising and price, 6 Advertising and quality, 7 Advertising and entry deterrence, I present research on advertising theory. Next, in Section 8, I describe the modern (second-group) empirical efforts. The modern (third-group) work is discussed in Section 9. Section 10 identifies new directions and omitted topics, and Section 11 concludes.

The survey is comprehensive and thus long. The sections are organized around topics, however, making it easy to locate the material of greatest interest. For teaching purposes, if a thorough treatment of advertising is planned, then the survey may be assigned in full. Alternatively, if the plan is to focus on a particular topic within advertising, then Section 2 and the section that covers the corresponding topic may be assigned. Section 2 provides a general context in which to understand any of the topic treatments found in later sections.

Section snippets

Views on advertising

In this section, I discuss the key initial writings that led to each of the three main views (persuasive, informative, complementary) of advertising. The assignment of economists to views is, to some degree, arbitrary, as it is commonly recognized that advertising can influence consumer behavior for different reasons. There are, however, important differences in emphasis among many of the key contributors. I begin with Marshall, 1890, Marshall, 1919 and especially Chamberlin (1933), who set the

Empirical regularities

Beginning in the 1960s and 1970s, as the distinctions between the persuasive and informative views became clear, a huge volume of empirical work emerged that evaluates the predictions of these two views. Much of the initial work follows the lead of Bain (1956) and Comanor and Wilson, 1967, Comanor and Wilson, 1974 and seeks empirical regularities at the inter-industry level. But many of the earlier efforts also search for regularities using data at the industry, firm or even brand level. As I

Monopoly advertising

In this section, I focus on positive and normative theories of monopoly advertising. The monopoly case is of interest in its own right, and it also represents a simple setting within which to begin the formal analysis of advertising. In subsequent sections, I consider more advanced topics, including multi-firm markets and monopoly advertising that signals product quality.

Advertising and price

Monopoly advertising may be inadequate, since the monopolist cannot appropriate the consumer surplus that additional advertising creates. But in markets with multiple firms advertising is also an important instrument of competition. The advertising of one firm may steal the business and thus diminish the profit of another. This business-stealing externality raises the possibility that advertising may be excessive. In multi-firm markets, it is thus unclear, a priori, whether advertising is

Advertising and quality

Nelson (1974b) predicts a positive relationship between advertising and product quality, especially for experience goods. In support of this prediction, he identifies the signaling-efficiency, repeat-business and match-products-to-buyers effects. As discussed in Section 3.2.5, however, the empirical literature offers mixed support for this prediction. I consider now recent theoretical analyses of advertising and quality. I organize this discussion around the three effects that Nelson (1974b)

Advertising and entry deterrence

With a few exceptions, the theory summarized above does not address the relationship between advertising and entry. This is an important omission, since the persuasive view hypothesizes that advertising exerts an entry-deterrence effect. As discussed in Section 3, the empirical support for this hypothesis is mixed. In the absence of an empirical resolution concerning the relationship between advertising and entry, theoretical analyses may be of special value.

In the tradition of Bain's (1949)

Empirical analyses

While inter-industry studies offer useful descriptions of economy-wide empirical regularities, they often suffer from important endogeneity and measurement concerns (as detailed in Section 3) and ultimately fail to identify the underlying structural parameters that describe how individual markets work. As mentioned in the Introduction, the modern (second-group) empirical analyses of advertising increasingly use new data sets, which are often constructed at remarkably disaggregated levels, and

Sunk costs and market structure

As Sections 5 Advertising and price, 6 Advertising and quality, 7 Advertising and entry deterrence reveal, an important lesson of game-theoretic models in industrial organization is that details may matter. Empirical efforts that follow the SCPP and seek inter-industry confirmation of sweeping causal hypotheses are thus too ambitious. But what are the alternatives? As illustrated by the NEIO studies reviewed in the previous section, one alternative empirical strategy is to focus on a particular

New directions and other topics

In this section, I briefly discuss two new directions for advertising research. The first direction concerns the use of advertising in media markets. This is a long-standing research topic that has enjoyed renewed attention in the past few years. The second direction is at an earlier stage and concerns the potential implications of findings in the fields of behavioral economics and neuroeconomics for advertising research. Finally, despite the length of this survey, many topics remain untreated.

Conclusion

This survey is written with two objectives in mind. A first objective is to summarize the economic analysis of advertising in a way that brings to the surface the more essential contributions and thereby clarifies what is known. To this end, I describe these contributions and summarize the main theoretical and empirical findings. These summaries are found at the close of the various sections (and subsections) above.

The second objective is to clarify how this knowledge has been obtained.

Acknowledgements

I thank Susan Athey, Alberto Martin, Martin Peitz, Per Baltzer Overgaard, Michael Riordan, Victor Tremblay, Ting Wu and especially Mark Armstrong and Rob Porter for helpful comments. Discussions with Andrew Pyo and Laura Silverman are also gratefully acknowledged.

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