This week I continue my series on the economics of advertising. Adding on to the introduction of the informative and persuasive view that I wrote about in my previous article, let’s proceed to consider some more specific contributions, and advertising’s potential influence on welfare. Have economists been able to come to a sweeping conclusion about the very unusual good ‘advertising’?
The answer to the above question is obviously ‘no’. Rarely do economists come to a sweeping conclusion about some phenomenon. As per usual, the answer is ‘it depends’. Kaldor (1950) brings a hallmark discussion to the economics of information. In this paper Kaldor argues for the persuasive nature of advertising and its uninformative nature. In particular an important insight is of the economies of scale in advertising. Informally this amounts to claiming that there are cost advantages to expanding and producing more. Intuitively, think of a local supermarket which advertises in the local newspaper every day for some inelastic price. This would mean, the more goods the supermarket brings in and sells, the lower the average cost of advertising (ignore demand and assume consumers can absorb the production).
This insight implies that advertising may lead to lower prices in the market as quantity expands, especially if these economies of scale effects are significant. However, Kaldor also claims that if advertising builds brand loyalty it may lead to higher prices (i.e. if advertising buys the firm some sort of monopoly power). Not surprisingly, welfare analysis results are quite equivocal in the literature. Dixit and Norman (1978) offer a model to examine the welfare effects of advertising to find that advertising is in general ‘excessive’ (not optimal for social welfare) in a monopoly setting. This finding however, assumes that the pre-advertising tastes of consumers are socially optimal, which is questionable. Later works examining the impact of advertising on welfare finds that monopoly advertising that lowers price is under-supplied.
Moving on to the informative view, Stigler (1961) explains how consumers may not have perfect information. The cost of searching is not free and due to this ignorance on the part of consumers, price dispersion is generated in the market. The implication of advertising in this setting is that it should reduce price dispersion as consumers become better informed. In terms of welfare, now the question is whether firms will provide advertising at a socially efficient level. Butters (1977) surprisingly find that indeed firms supply a socially efficient amount of advertising.
There is another dimension to the informative view of advertising, the information of product quality, indirectly embedded in the advertisement. This is different from the search goods interpretation as previously, where advertising helped alleviate ‘informational differences’. Now, advertising is portraying information about ‘actual differences’ in the quality of the product. The first formal modeling of this effect was by Schamalensee (1987). Schamalensee emphasized a difference in marginal costs depending on the quality of the good. The intuition is that a higher quality good costs more to produce, and under the assumption that all sellers must charge a single price within the market, low quality firms may advertise more since, their markup on the initial sale will be higher than that of the high quality firm. However if we are thinking in terms of efficiency and marginal cost (intuitively, think: a more efficient firm with a lower marginal cost may make the best products), then the results could be interpreted in a converse manner.
Overall, there is no bright-line conclusion to whether advertising is good or bad in reality. However economists have been able to model certain environments to see how advertising operates within the assumed setting. Next week, I will discuss some of the empirical findings in the literature and examine what real data has to say!
Butters, Gerard R, (1977), Equilibrium Distributions of Sales and Advertising Prices, Review of Economic Studies, Vol. 44(3), pages 465-91, October.
Dixit, A. and Norman, V. (1978). Advertising and welfare. Bell Journal of Economics Vol. 9, pages 1–17.
Kaldor, N. (1950). The economic aspects of advertising. Review of Economic Studies Vol.18, pages 1–27.
Schmalensee, Richard, (1989). Inter-industry studies of structure and performance, Handbook of Industrial Organization, in: R.
Schmalensee & R. Willig (ed.), Handbook of Industrial Organization, edition 1, volume 2, chapter 16, pages 951-1009 Elsevier.
Stigler, George J. (1961), The Economics of Information, Journal of Political Economy, Vol. 69, pages 213.