Lecture 3 - Advertising

1. Definition and Conceptual Foundations

1.1 Definition of Advertising

Advertising is a paid, non-personal communication about an organisation and its goods or services, transmitted to a target audience through mass media.

From an economic perspective, this definition highlights three core features:

  • Paid: advertising is costly and therefore a strategic choice subject to optimisation.
  • Non-personal: communication is not individually negotiated, distinguishing advertising from direct selling.
  • Mass media transmission: advertising exploits scale, allowing firms to reach large audiences simultaneously.

Advertising is therefore best understood as a strategic instrument rather than a purely informational add-on.

1.2 Overview and Historical Context

Limited interest before the 20th century

Early economic theory largely ignored advertising. Under the assumptions of:

  • Perfect competition
  • Symmetric information
  • Fixed and stable preferences

advertising serves no economic purpose. Prices fully summarise information, firms are price takers, and output is determined entirely by market-clearing conditions. In such a world, advertising would be wasteful expenditure with no effect on equilibrium outcomes.

This explains why advertising played little role in classical price theory.

First economic theories of advertising

Systematic economic analysis of advertising began with Marshall (1890) and Chamberlin (1933). These contributions relaxed the assumptions of perfect competition by introducing:

  • Product differentiation
  • Downward-sloping demand curves at the firm level
  • Market power driven by brand and variety

Advertising becomes meaningful precisely because firms face differentiated demand and can influence consumer behaviour.

2. Competing Economic Views of Advertising

2.1 Persuasive View of Advertising

The persuasive view treats advertising as a tool that shifts or reshapes preferences, rather than simply conveying information.

Key roles attributed to advertising under this view include:

  • Entry deterrence through increased sunk costs
  • Spurious product differentiation, where perceived differences exceed real ones
  • Allocative inefficiencies, as prices exceed marginal cost

Economic intuition:

  • Advertising reduces the perceived substitutability between products
  • Demand becomes more inelastic
  • Firms can sustain higher mark-ups and profits

Under this view, advertising may reduce welfare by distorting preferences rather than improving information.

2.2 Informative View of Advertising

From the 1960s, Ozga (1960) and Stigler (1961) reframed advertising as a mechanism for reducing information frictions.

Advertising:

  • Informs consumers about prices, availability, and characteristics
  • Reduces search costs
  • Improves market transparency

Economic implications:

  • More informed consumers compare prices more effectively
  • Competitive pressure intensifies
  • Prices may fall and consumer surplus may increase

In this framework, advertising can enhance allocative efficiency and welfare, especially in markets where consumers are initially poorly informed.

2.3 Complementary View of Advertising

Stigler and Becker (1977) proposed a more radical interpretation: advertising can itself be a consumption good.

Under this view:

  • Consumers derive direct utility from advertising
  • Advertising enters the utility function rather than merely affecting beliefs

Examples include lifestyle branding, entertainment-based advertising, and status signalling. Advertising is not just persuasive or informative but intrinsically valued by consumers.

This perspective reconciles advertising with rational consumer behaviour without assuming unstable preferences.

3.1 Firm Behaviour and Advertising Choice

A firm that chooses both price and advertising solves the following profit maximisation problem:

Where:

  • is price
  • is advertising expenditure
  • is demand, increasing in and decreasing in
  • is total production cost
  • is the cost of advertising

3.2 Advertising Intensity and Optimal Advertising

Definition of Advertising Intensity

Advertising intensity measures the importance of advertising in a firm’s overall strategy and is defined as the share of advertising expenditure in total revenue:

This normalisation is essential because it allows meaningful comparisons across firms, industries, and countries of different sizes. Economic analysis therefore focuses on advertising intensity rather than absolute advertising spending.

Advertising and Demand Elasticities

Demand depends jointly on price and advertising:

Define:

  • Advertising elasticity of demand:
  • Price elasticity of demand:$$
    \varepsilon_P = - \frac{\partial Q}{\partial P} \cdot \frac{P}{Q}

Optimal Advertising: Dorfman–Steiner Condition

A firm with market power chooses price and advertising to maximise profits:$$
\pi(P,A) = P Q(P,A) - TC(Q(P,A)) - S(A)

\frac{S(A^)}{P^ Q^*} = \frac{\varepsilon_A}{\varepsilon_P}

This expression characterises the optimal share of revenue spent on advertising. --- ### Economic Intuition The Dorfman–Steiner condition implies that: - Advertising intensity is **higher** when demand is more sensitive to advertising $(\varepsilon_A$ high$)$ - Advertising intensity is **lower** when demand is more sensitive to price $(\varepsilon_P$ high$)$ Advertising and price competition are therefore strategic substitutes. When consumers respond strongly to prices, firms compete by lowering prices rather than increasing advertising. When consumers respond strongly to advertising, firms rely more heavily on advertising to increase demand. --- ### Market Structure Implications The model explains systematic differences in advertising intensity across markets: - **Differentiated goods markets** - High $\varepsilon_A$, low $\varepsilon_P$ - High advertising intensity - Typical of monopolistic competition and oligopoly - **Homogeneous goods markets** - Low $\varepsilon_A$, high $\varepsilon_P$ - Low advertising intensity - **Perfect competition** - Firms are price takers - Advertising has little strategic role - Advertising intensity tends to zero - **Pure monopoly** - Limited competitive pressure - Weak incentives to advertise - Advertising intensity also low Advertising intensity is therefore highest in markets characterised by product differentiation and intermediate levels of competition. --- ### Welfare Considerations The Dorfman–Steiner condition describes the **private-profit optimal** level of advertising, not necessarily the socially optimal level. - If advertising is **informative**, higher advertising intensity can improve welfare by reducing search costs and increasing competition - If advertising is **persuasive**, high advertising intensity may reflect socially excessive spending that increases market power - If advertising is **complementary**, welfare effects depend on whether the additional utility generated by advertising exceeds the associated deadweight loss As a result, observed advertising intensity alone is insufficient to determine welfare outcomes. --- ### Exam-Focused Takeaways - Advertising intensity is defined as advertising expenditure divided by total revenue - Optimal advertising satisfies the Dorfman–Steiner condition - High advertising elasticity increases optimal advertising intensity - High price elasticity reduces optimal advertising intensity - Advertising intensity is highest in differentiated markets such as monopolistic competition - The welfare effects of advertising depend on whether advertising is informative, persuasive, or complementary --- ### Economic Interpretation Advertising affects profits through two channels: 1. **Demand expansion or reshaping**: $\frac{\partial Q}{\partial A} > 0$ 2. **Cost trade-off**: advertising is costly and competes with other uses of firm resources The firm chooses advertising up to the point where the **marginal revenue from increased demand equals the marginal cost of advertising**. This framework makes clear that advertising is: - A strategic investment - Endogenously determined - Closely linked to pricing power and demand elasticity --- ## 4. Advertising, Market Power, and Welfare Advertising can both increase and decrease welfare depending on its dominant role: - Informative advertising tends to be **pro-competitive** - Persuasive advertising may increase **market power** - Complementary advertising blurs the line between consumption and persuasion The welfare effects of advertising are therefore **theoretically ambiguous** and must be assessed empirically and contextually. --- ## Exam-Focused Takeaways - Advertising is irrelevant under perfect competition with full information. - Product differentiation creates a role for advertising. - Persuasive, informative, and complementary views imply very different welfare conclusions. - Advertising enters firm optimisation through demand, not just costs. - Understanding *which* role dominates is central to policy and competition analysis. --- ## References Chamberlin, E.H. (1933) *The Theory of Monopolistic Competition*. Cambridge, MA: Harvard University Press. Marshall, A. (1890) *Principles of Economics*. London: Macmillan. Ozga, S.A. (1960) ‘Imperfect markets through lack of knowledge’, *Quarterly Journal of Economics*, 74(1), pp. 29–52. Stigler, G.J. (1961) ‘The economics of information’, *Journal of Political Economy*, 69(3), pp. 213–225. Stigler, G.J. and Becker, G.S. (1977) ‘De gustibus non est disputandum’, *American Economic Review*, 67(2), pp. 76–90.