As the title of the article suggests, this week I am writing about the economics of advertising. I will be writing a series of articles exploring the advertising literature. We start the series off by an overview of the existing literature and how economists think about advertising. Advertising is a particularly interesting topic of study because it is literally ‘everywhere’ if you are a participant in a market economy. From all the screens we own, to the side of buildings, even on the grass we play sports on. Unlike many other areas of economics which are quite abstract and mysterious to the non-economist, advertising does not require you to have any formal knowledge of economics to entertain the thought of its effects on us.
BUT, since I am an economist, let’s take a look at how economists have historically modeled and analyzed the world of advertising. The vast majority of the economics of advertising literature bloomed during the 20th century and Chamberlin’s (1933) integration of advertising in his theory of monopolistic competition is the obvious milestone for the role of advertising in formal microeconomic models. Chamberlain makes very important contributions to our understanding of advertising.
The most interesting contribution is the idea that advertising can be persuasive and informative. For advertising to be persuasive, it means that advertising can alter the preferences of the buyers to build ‘brand loyalty’ reinforcing a combative role for advertising. On the other hand advertising may be informative, which means that advertising provides buyers with better information on which to base purchasing decisions on, suggesting a constructive role for advertising.
Theoretically, it is difficult to elicit the net effects of advertising, but it is obvious both effects coexist. If we believed that information was persuasive, we would expect advertising to operate as an entry deterrent, as the incumbent firms who have already established their ‘brand’ enjoy the economies of scale from their advertising spending. New entrants looking to enter the industry will require enormous amounts of advertising expenditures to even begin competing with these established firms. Also, the price inelasticity the persuasive view suggests, implies that firms can set prices higher than marginal cost for extra profits, and this may provide an explanation for why firms are so willing to vigorously engage in advertising despite how expensive it is.
The informative view suggests something entirely different. Sitgler (1961), Nelson (1975), Butters (1977) and many other writings set the foundation for the informative role of advertising. Taking this stance, the price of the advertised product should be lower as the price elasticity of the product will increase with greater information on different prices in the market. Also, this view suggests that advertised products are generally of a higher quality. Why? If advertising is informative and offers the firms demand expansion, the firms that have the strongest incentives to engage in such activities are the more efficient ones which have more to gain from more people buying their products even at lower prices. This observation is quite interesting because even seemingly uninformative advertisements may be disseminating indirect information to the potential buyer of the product.
We have covered in a VERY basic manner the economic theory underlying advertising, but what weight does such theory carry without empirical evidence of such effects? Obviously, different views of advertising will dominate in different industries. My succeeding articles will explore the theory at a more granular level, and take a look at some empirical contributions in the literature, so stay tuned!
Butters, Gerard R, (1977), “Equilibrium Distributions of Sales and Advertising Prices,” Review of Economic Studies, Wiley Blackwell, vol. 44(3), pages 465-91, October.
Chamberlin, Edward (1933), “The Theory of Monopolistic Competition”, Cambridge, MA: Harvard University Press.
Nelson, Phillip (1975), “The Economic Consequences of Advertising,” Journal of Business, 48, 213-41.
George J. Stigler, (1961), “The Economics of Information,” Journal of Political Economy, University of Chicago Press, vol. 69, pages 213.