Why Do Firms Advertise

Now advertising is a prominent feature of consumers economic life, it reaches consumers through all means one can think of, including TV sets, radios, newspapers, magazines, mailboxes ,websites and more. According the survey by Advertising Age (2007), in the U.S. 2006, total advertising cost of Microsoft is $11.5 billion; Coca Cola spent $2.5billion on advertising; Yahoo devoted $1.3 billion on their advertisement; eBay, Google and Starbucks incurred $871 million, $188 million and $95 million on advertisement respectively. All of the figures and evidences showing that advertising expenditure can be huge and it is indeed a big industry. Often, people may question: why do firms advertise? Why do they spend big amount money just on advertising? In order to answer this question, we need to have a background of advertising analysis history. In next section we will illustrate the background of advertising and the researches had been done on this topic.

Background

In 19th century, because of the focus of perfect competition and the limited methods of transition, people did not discovery much role of advertising. So the analysis of advertising is almost blank in 19th century. It became a mature topic for economic research at the beginning of 20th century. The work of Marshall (1890, 1919) who gives some insightful distinctions was the beginning of analysis on advertising. However, empirical research of advertising appeared in 1950s. From 1950s to 1970, a great quantity of literature investigated the relationship between advertising and many other variables, such as price and profit. According to this, the methodology applied in this time was regression model as well as its robust examination. The interpretation of the researches in this period suggest no single view of advertising is valid in all setting (Bagwell, K. 2005). After 1980s, empirical analysis of advertising trended to focus on new source of data, and was guided stronger and stronger by theoretical work.

Properties of advertising

By the progress of advertising researches for more than one century, we can conclude three properties of advertising, which are persuasive, informative and complementary. However the producer who launches his advertising is not interested in whether his advertising convey more information, complementary to the products that is advertising or change any conception of consumer. What they really care about is to sell more of his products. That why firms do advertising. In order to realize the aim, the firms must choose their advertising who follow the three properties of advertising.

Advertising is persuasive saying that advertising can change consumers’ tastes and induce artificial products’ distinction and brand loyalty. That means the demand for the firm’s products becomes inelastic (Bagwell, K. 2005). We can predict that the firm can set a high price if their advertising achieved the effects we illustrate above. This situation may lead to monopoly. Although advertising does not “create” value, it creates spurious product’s distinction, and lead to the high prices even high profits to the producer. This property of advertising has already well defined and demonstrated by Chamberlin (1933), he emphasis the effects we explain above as entry-effect: once firm set brand loyalty by his advertising, it sets the barrier to entry for the other firm who produce the same or similar products, thus he can charge high price and gain significant profit. The effect equals to establishing a kind of monopoly. Then this property was developed further by Kaldor (1950) who distinct the effect of advertising in direct and indirect on a welfare level. He find the consequences following: “(a) that the larger firms are bound to gain at the expense of the smaller ones; (b) if at the start, firms are more or less of equal size, those that forge ahead are bound to increase their lead, as the additional sales enable them to increase their outlay still further”, and get the same conclusion with Chamberlin.

Advertising is informative is another properties of advertising. Information is conveyed or generated by advertising because of inefficiency of market. That means consumer information is imperfect in the market. The search for the information of products, such as price and quality are costly for consumer. The profound works on this aspect is Nelson (1970, 1974). Nelson (1970) makes a fundamental distinction of “search qualities” and “experience qualities”. Search qualities can be determined before purchase fyuunguiho, while experience qualities only can be estimated after purchase. Then Nelson find in his another paper that the indirect information has more significant impact on “experience qualities”. He also point out demand expanding advertising may has huge attract to high quality firms, since low quality firms may have a lower marginal cost, so high quality firms cline to relay more on indirect information conveyed by advertising. So advertising can be seen as the endogenous response to the imperfect market.

Complementary to the product is the third property of advertising. Unlike the persuasive property, advertising does not change the consumer’s taste. Moreover, it contains information thus affect consumer’s behavior. For instance, consumers have response to social reputation, more the product is advertised, more reputation it may gained. Thus, consumers intend to consume this product in order to make them feel better. The advantages of this property is that it allows advertising contain indirect information base on the persuasive property.

Because of these properties, advertising either alters the preference of consumer, convey indirect information to consumer or do both. Hence advertising can increase the sale of products that is the main reason why firms advertise. In the following section, we will analyze how advertising assist high-quality products.

Assistant of advertising on quality

A series of papers of Nelson (1970, 1974, 1978) predict the positive relationship between advertising and quality. Under this case, advertising is still indirectly informative, even if a great deal of observed advertising contains no direct information about product quality. However, consumers still can get the unobservable product quality by advertising reasoned by the indirect information that advertising conveyed. That is, advertising signal quality (Kihlstrom and Riordan, 1984). This notion is also originates from the series articles of Nelson in 1970s. According to the prior section of advertising’s informative property, we know that Nelson differ the search quality from the experience quality. The argument of positive relationship between advertising and quality is based on this definition. The main point of Nelson is what we illustrate at the beginning of the section: Although many advertisements may not have direct information or have little value to consumers, advertising it-self may convey indirect information to consumers. For example, consumer intends to regard a big expenditure on advertising as a signal of high-quality (Hertzendorf, 1993). Nelson says: “Whatevertheir explicit reasons, the consumers’ ultimate reason for responding to advertising is their self-interest in doing so. . . . If it were not in consumer self-interest to respond to advertising, then the consumers’ sloppy thinking about advertising would cost enough that they would reform their ways.” Implies that whether or not consumer aware of the relationship between advertising and quality do not matter with their response to advertising.

Meanwhile, only when high quality firms find that investment on more advertising is profitable than low quality firms, the indirect quality information can be conveyed by advertising. Spence (1973) argues that the fundamental thing to advertising is not the return but the cost to signaling, since the returns to advertising is greater for high quality firms if the costs of advertising are the same for all firms. Repeat purchases were analyzed in Nelson (1974), he find an asymmetry can be created in the returns which can be seen as a support to advertising signal quality. However, Nelson does not project an empirical model under this issue.

An empirical market model which related advertising and repeat purchases was established by Richard Schmalensee (1978). However, this paper found low quality firms gain more profit than high quality firms which is inconsistent with the rational behavior of consumer. So this model just follows Nelson’s ideas approximately, however does not capture the real role of advertising as quality signal.

Another model which describe the correlation between advertising and quality, examine advertising signals quality is the work of Johnsen (1976). He found that only high quality firms advertise and their advertising signals quality (Kihlstrom and Riordan, 1984). In the model, Johnsen assume that all the consumers are “examiners”, they will buy the products which spent a huge amount money on advertising. If these “examiners” finds what they brought are high quality, they will keep in mind and continue to purchase these products. Thus the repeat sales have been established for high quality producers but the low quality producers can not do so. This result is a litter different from Nelson’s. However Klein and Leffler (1981) argued that advertising signals quality but the low quality producers have advantages on both average cost and marginal cost. Wolinsky (1981, 1983) project the idea that fixed costs, for example, advertising expense, may signal quality. The main point of this work focuses on prices as signals of quality while consumers search for quality (Kihlstrom and Riordan, 1984).

The first model that follows exactly Nelson’s ideas was constructed in Milgrom and Roberts (1986). In their signaling quality game, monopolist choose to produce high quality product or low quality product, and the monopolist is insider, that is he is well informed about the true quality of his product, while consumer is outsider. In a sequential select, the high quality monopolist and low quality monopolist will choose different strategies of pricing and advertising. So consumers can differ the true quality by observing the firm’s pricing and advertising strategies. They found that in a separating game, the high quality producer will choose a costly pricing and adverting strategy to the low quality producer, thus it is hard to the low quality to mimic. The model Milgrom and Roberts applied explore the relationship between quality and both price and advertising expenditures. However, there is a weakness of the assumption that is the expenditure of the firm’s advertising can not observe totally by consumers, since there are various ways that is hard to estimate to advertise nowadays.