As we wait for class to start, please sign in for today’s attendance tracking: [KEYWORD = SUBTRACT] Text to 37607: SUBTRACT netID Go online to: PollEv.com/dyson or netID LECTURE 4 & 5: PRODUCT DIFFERENTIATION AND PERSUASIVE ADVERTISING AEM 4550: Economics of Advertising Prof. Jura Liaukonyte Lecture Plan LI and Dorfman Steiner revisited Product differentiation and advertising Taxonomy of product attributes Search Experience Credence Taxonomy of advertising types Persuasive Advertising PBS Frontline: Persuaders Lerner Index Definition Formula Measures the market power of a company based on the price it can charge The higher the number, the more pricing power the firm has Mark-up power reflects monopoly power PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark-up will increase. L = (p - MC)/p = 1/|EP| Advertising and Monopoly Power Assume a firm faces a downward-sloping demand inverse curve but one that shifts depending on the amount of advertising A that the firm does P=P(Q, A) Recall, the Lerner Index, LI L = (p - MC)/p = 1/|EP| Where |EP| is the price elasticity of demand Advertising and Monopoly Power The elasticity of output demand with respect to advertising EA A P *Q Q / Q A / A EA | Ed | A Q Q A = Advertising/sales ratio Dorfman-Steiner Condition For a profit-maximizing monopolist, the advertising-tosales ratio is equal to the ratio of the elasticity of demand with respect to advertising relative to the elasticity of demand with respect to price. A Intuition Behind D-S A P *Q EA | Ed | Recall: the greater the demand elasticity, the lower the optimal price. Price-cost margin is smaller when elasticity is higher. Since the price-cost margin is smaller with elastic demand, the gain from advertising is also smaller even if the increase in quantity demanded is the same. The marginal gain from advertising is greater the greater the price-cost margin. Dorfman-Steiner The Dorfman-Steiner formula relates the advertising-to- revenues ratio to price-cost margin and elasticity. The advertising-to-sales ratio is greater the greater the advertising elasticity of demand and lower the price elasticity of demand (or the greater the price-cost margin). Example Suppose you have been hired to marker a new music recording that is expected to have target sales of $20 million for upcoming year The marketing department has estimated that 1% Scenario increase in advertising will translate to 0.5% increase in sales And that 1% increase in the price of the recording would reduce the number sold by about 2% Question How much money should you commit to advertising the recording in the coming year? Advertising to Sales Ratios This ratio varies between industries Salt industry: a-s-r = 0 to .5% Breakfast cereals industry: a-s-r= 8% to 13% Advertising intensity depends on: The type of product Advertising elasticity of demand Price elasticity of demand Highest Ad-to-Sales Ratios Lowest Ad-to-Sales Ratios Example: Credit Card Industry Advertising to Sales Ratios 35.00% 30.00% Percentage 25.00% Bank of America 20.00% JP Morgan Chase Citigroup 15.00% American Express Industry 10.00% 5.00% 0.00% 2010 2009 2008 Year 2007 2006 • Industry Average is 7.6% and has grown over the last few years Example: Airline Industry Ad to Sales Ratios 3 2.5 2 AMR Delta 1.5 Southwest US Airways 1 0.5 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Ad to Sales Ratios High or low? Transportation/Travel industry =1.9 Consumer Products, Books, PayTv, Communications, all > 5 Downward Trend Market Concentration Numbers and size distributions of firms Ready-to-eat breakfast cereals: high concentration Different Market Structures Measurements of market structures Newspapers: low concentration Concentration ratio, Herfindahl-Hirschman Index (HHI) Lerner Index (LI) Industry Concentration Four-Firm Concentration Ratio The sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales C 4 w1 w 2 w 3 w 4 , where w1 Herfindahl-Hirschman Index (HHI) Si ST The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000 S wi2, where wi = Si/ST. Measure of concentration Firm Rank Market Share (%) Squared Market Share 1 25 625 2 25 625 3 25 625 4 5 25 5 5 25 6 5 25 7 5 25 8 5 25 Concentration Index Measure of concentration Market Share (%) Firm Rank 1 2 3 4 5 6 7 8 Concentration Index Σ 25 25 25 5 5 5 5 5 Squared Market Share Σ 625 625 625 25 25 25 25 25 Measure of concentration Market Share (%) Firm Rank 1 2 3 4 5 6 7 8 Σ Assume firms 4 and 5 merge Concentration Index 25 25 25 5 5 5 5 5 10 Squared Market Share Σ 625 625 625 25 25 25 25 25 100 Measure of concentration Market Share (%) Firm Rank 1 2 3 4 5 6 7 8 Σ The concentration indices change Concentration Index 25 25 25 5 5 5 5 5 10 Squared Market Share Σ CR4 = 80 85 625 625 625 25 25 25 25 25 100 H = 2,000 2050 HHI The Herfindahl-Hirschman Index – the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50) Definition Properties In perfect competition, the HHI is small In monopoly, the HHI is 10,000 (100 squared) A popular measure with the Justice Dept in the 1980’s Example HHI < 1000 characterized competitive markets HHI > 1800 would bring Justice Dept challenge to proposed mergers E.g. The cigarette industry is highly concentrated with only 8 firms and a Herfindahl-Hirschman Index (HH1) of 2623 Example: Candy and Chocolate Industry Candy v. Chocolate CANDY 1.00% Mars Incorporated HHI (for top 4) = 1141 CR ₄ = 59% Medium level concentration ->Concentration is increasing! The Hershey Company 1.00% 2.00% Tootsie Roll Industries 2.00% 2.50% 13.40% 3.00% 4.00% 49.50% 21.60% Ferrara Pan Candy Company 1,039 businesses overall!! Jelly Belly Candy Company Russell Stover Candies Inc. Kraft Foods CHOCOLATE Nestle Inc. HHI (for top 4)= 2941.81 Cr ₄ = 78.1% High level of concentration Mars Incorporated The Topps Company Other 25.00% 39.00% 20.00% 0.50% 0.50% Nestle Russel Stover 10.00% 518 Businesses overall!! The Hershey Company Lindt & Sprungli Guittard Chocolate Company See's Candies 4.00% 1.00% Other CR₄ and HHI: Candy Industry The HHI for just the top 4 companies in the industry is 2941.81. The CR ₄ for the industry is 78.1%. Therefore, the industry is highly concentrated with only a few major firms holding a majority of the market share. CR ₄ = 49.5 + 21.6 + 4 + 3= 78.1% *Hershey and Mars Inc. alone hold 71.1% of the market share. -Note that students calculated HHI incorrectly (need to add squared market shares for top 50 companies, not only top 4) Example: Credit Card Industry Market Definition All Credit Lending Institutions with their own card 27.2% 19.2% 18.9% 17.2% 4.0% J.P. Morgan Chase & Co. Bank of America Corporation Citigroup Inc. American Express Company Capital One CR4: 83.2 HHI: 1810-1850 MARKET SHARE J.P. Morgan Chase Bank of America Corporation American Express Company Capital One Total Number of Companies: 192 5% 20% 31% 22% 22% Citigroup Inc. Stylized Facts About Advertising Volume of advertising expenditures is large. For the Facts US, advertising expenditures total to over 2% of GDP Underneath this national total is a wide variety in firm advertising behavior Car makers (e.g., GM) and household product firms (e.g., Proctor & Gamble) spend the most on advertising Basic patterns that emerge are: Patterns Correlation between advertising & market power Consistency of advertising behavior within industries—big advertisers remain big over time and across countries Worldwide Ad Spending by Region (2013) Advertising by Media in the US TOP 10 Brands in 2012 Product Differentiation Products are different if there is some objective characteristic Definition Variation or property, real or perceived, that provides a basis for buyers to choose one over the other. Product differentiation may lead to reduced own -price elasticity. As the degree of differentiation increases, the price elasticity will decrease. Product Brand Service Provided Packaging Location Condition of Sale Product Differentiation as an Entry Strategy Strategy Product differentiation to create a niche market. Product differentiation to deter entry. Ad Elasticity and Concentration 1 Each firm’s advertising elasticity decreases as concentration decreases. 2 The more fragmented the industry is, the lower the benefit from advertising that is captured by the firm that pays for it. 3 With more firms in the industry, a firm’s "split of the pie" is smaller. Advertising and Product Differentiation Advertising product characteristics increases product differentiation. Consumers are more informed about objective product differences. Firms can create some sort of subjective product difference. Advertising in this case softens competition due to heightened awareness of product differentiation. Soften competition: the industry is less competitive and firms have more market power. Strengthen competition: the industry is more competitive and firms have less market power. Firms are able to avoid Bertrand competition by advertising. Perceptual Maps Perceptual Map: Credit Cards Perceptual Map: Credit Cards Uniformity American Express Chase Accessibility Selectivity B of A Citi Variety Product Positions in Characteristics Space What could advertising do to change these positions? Are perceived and real characteristics the same thing? On the other hand… Advertising can increase price competition when firms advertise about their prices. If prices were artificially high due to imperfect price information, then firms have an incentive to advertise about their prices to attract more consumers. Rival firms will soon follow suit and advertise about their prices. This leads to higher expenditures on advertising and lower prices. Advertising in this case strengthens competition due to heightened awareness of prices. Taxonomy of Products and Their Attributes Understanding Customer Search Attributes Experience Attributes Credence Attributes Determine prior to Can be discerned only Any aspects of a good or purchasing the goods and/or services. service that the after purchase or customer must believe in during consumption or Like color, price, use. But cannot personally freshness, style, fit, evaluate even after Examples: Friendliness, feel, hardness, and purchase and taste, wearability, fun, smell. consumption. and customer Examples: supermarket satisfaction. Examples: the expertise food, furniture, of a surgeon or clothing, automobiles, and houses are high in mechanic, the search attributes. knowledge of a tax advisor, or the accuracy of tax preparation software. Taxonomy of Goods-Nelson (1974), Lieberman and Flint-Goor (1996) Search Goods Non-Durable Exp. Goods Durable Exp. Goods Experience Services Credence Services Clothing Furniture Footwear Carpets Mattresses Health/Beauty Cigarettes Food Cleaners Newspapers Office Supplies Housing Autos Hardware Drugs Glass Software Signs Books Sporting Goods Hobbies Utilities Advertising Transportation Vacations Education Training Tours Banking Car Rentals Entertainment Direct Mail Real Estate Cargo Job Placement Information Nursing Homes Sports Clubs Hotels Waste Collection Landscaping Investments Trusts Portfolio Management Mutual Funds Insurance Health Care Weight Control Car Repairs Key Point Firm (Brand) Reputation is more important for experience goods than search goods and most important for credence goods. Has implications on advertising effects on demand. Product Attributes Most Goods Most Services Difficult to evaluate Easy to evaluate Clothing Restaurant meals Computer repair Chair Lawn fertilizer Education Motor vehicle Haircut Legal services Foods Entertainment Complex surgery High in search attributes High in experience attributes High in credence attributes How the Internet affects … Search goods: Can facilitate consumers' ability to obtain attribute information. Experience goods: Difficult to provide enough experience for consumers to assess the benefits of the product Offline trial & Online purchase Credence goods: How to help consumers form a set of beliefs about the quality of the product? Access to other people's beliefs about the quality of the product such as product testimonials Advertising Taxonomy 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, 3-4 views have emerged, with each view in turn being associated with distinct positive and normative implications. Main Views of Advertising Persuasive Informative Complimentary Memory Jamming (Reminder) Life Cycle of Product Persuasive Advertising Persuasive Advetising The persuasive view holds that advertising alters consumers' tastes and creates spurious product differentiation The demand for a firm's product becomes more inelastic Advertising results in higher prices. Such 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 differentiation and brand loyalty. Persuasive Advertising and Product Types Recall, reputation is more important for experience goods than search goods and most important for credence goods. Reputation and Persuasion are close synonyms in this case. Among which type of products will we observe high levels of persuasive advertising? Search, Experience or Credence? The Pervasiveness of Persuasion The average person is exposed to 300-400 persuasive messages per day from the media alone (Rosseli, Skelly, & Mackie, 1995) The average person is exposed to 1,000 commercials per week (Berger, 2004) An average of $800 per person is spent on advertising in the U.S. each year (Berger, 2004) Obvious Forms of Persuasion A 30 second spot for Super Product Placement on American Idol Bowl costs $3-4 million for a 30 second spot. Product placements in movies and TV amounted to $2.5 billion in 2005 (PQ Media). Morgan (2005) “between 15-30 products are inserted in every half hour of television programming”. Product Placement http://www.brandchannel.com/brandcameo_film s.asp Featured Brands: Apple, Bell, Cadillac, Chock Full O’Nuts, Chrysler, Cisco, Ford, Ford Mustang, Hill-Rom, HP, Lacoste, Listerine, Los Angeles Dodgers, Mercedes, Motorola, Pepsi, Philips, Pontiac, Pyrotect, Rolls Royce, San Francisco Giants, Sharp, The North Face, The Riviera Hotel and Casino, Timberland, Toyota, United States Parachute Association Featured brands: Apple, Belstaff, BMW, Citibank, Datascope, Ford, Ford Mustang, Hamilton, Honda, Hummer, JVC, Kleenex, Loews, Magnavox, McDonald's, MetLife, Mobil, Nautilus, NBC, Nissan, Panasonic, Ronzoni, Salvatore Ferragamo, Sbarro, Spam, Staples, Tic Tac, Time, Verizon, Viking, XM Satellite Radio Model of Persuasive Advertising Total of N consumers in the market. Each consumer will buy only one unit of the primary good. Each consumer has a different value, vi, for the primary good. Advertising increases each consumer’s value by the same factor, , regardless of their initial value. Thus each consumer’s value with advertising is * vi. Model of Advertising and Crowd Appeal * $ Demand with advertising Profit Demand without advertising MC Quantity Model of Persuasive Advertising Increase in consumers’ willingness to pay, , is a function of the amount spend on advertising, s. As s increases, (s) increases, as does consumer demand and profit. Firms will select the level of advertising that maximizes profit, i.e., the level of s where the marginal revenue from s is equal to the marginal cost of s. Model of Persuasive Advertising In this model, higher levels of advertising lead to higher prices because the advertising increases the consumers’ willingness to pay. Also, advertising can increase consumer surplus as well as firm profit, since advertising increases a consumer’s value. More about that later, when we talk about complementary view. PBS Frontline: PERSUADERS http://www.pbs.org/wgbh/pages/frontline/shows/persuaders / Complementary Advertising Complementary View Consumers possess stable preferences Advertising directly enters these preferences in a manner that is complementary to the consumption of the advertised product Advertising may contain information and influence consumer behavior for that reason The consumer may value “social prestige” that is created by advertising Complementary vs. Persuasive The lines between complementary and persuasive are blurred, because it is hard to know whether ads change preferences or are part of consumer’s utility. Complementary View Associated with the Chicago School When a firm advertises more, its product becomes more attractive to the consumer “The household is made to believe – correctly or incorrectly Definition – that it gets a greater utility of the commodity from a given input of the advertised product” Consumer may value social prestige and advertising thus positions the product so that its consumption provides social prestige Firms may compete in the same commodity (e.g., prestige) Implication market even though they produce different market goods (e.g., jewelry and fashion) and advertise at different levels. Mission Statement “Louis Vuitton must continue to be synonymous with both elegance and creativity. Our products, and the cultural values they embody, blend tradition and innovation, and kindle dream and fantasy.” Price Premium Pricing Luxury image Selling Point Never on sale!! Price range: Handbags: $550 - $3,700 Wallets: $200 - $700 LVMH Moët Hennessy • Louis Vuitton French holding company and one of the world's largest luxury goods conglomerate. Mass-Commercialization of Luxury Many luxury handbags are mass-produced in China. The average markup for a luxury handbag is ten to 12 times production cost (marginal cost!). Louis Vuitton's markup is up to 13 times production cost. Family-owned companies that used to create exquisite bags, shoes and clothes, have been taken over by multi-billion dollar conglomerates. Luxury Markets Asia is now the biggest market for luxury brands Strange? the U.S. and Europe are wealthier (per capita) Luxury market in Japan is most alive: 40 % of all Japanese own a Vuitton item Why such a global discrepancy? Is True Luxury Dead? Not all E.g. Hermes Kelly and Birkin bags are painstakingly made in workshops in France; Classic perfume Chanel No.5 is still created using the finest ingredients in a small scale operation. Example: Credit Card Industry Complementary Advertising •American Express •Ranked #1 most trusted company •24th best global brand •Targets consumers with $100,000 to $1 million annual income •Consumers see card as a luxury •Gold Card, Platinum Card •Other companies are competing with "metallic" or "gem" cards