Part III. Sources of market power
Chapter 5. Product differentiation
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2009
Introduction to Part III
Case. Competition in the banking deposit market
• There exists market power
• Positive intermediation margins
• Lerner index: US, 23% / Japan, 20% / EU, 15%
• Where does it come from?
• Consequence of firms’ conduct
• Marketing mix: Price - Product - Promotion
• Price  analysis of pricing strategies, see Part IV
• Product  Product differentiation  Chapter 5
 Web-banking, network of ATM, ...
• Promotion  Advertising  Chapter 6
 Informative: “Call 1-800 ING Direct. Hang up richer”
 Persuasive: “Britain’s best business bank” (Allied Irish)
 Complementary: “Washington Mutual. More human
interest”
© Cambridge University Press 2009
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Introduction to Part III
Case. Competition in the banking deposit market
• Where does it come from?
• Consequence of market environment
• Consumer inertia  Chapter 7
• Because of a lack of information
 It’s time-consuming to compare deposit rates of
competing banks (and read the small prints)
 Source of price dispersion
• Because of switching costs
 Moving accounts from one bank to another takes time
(and possibly money)
 “Bargain-then-rip-off” pricing
 Customer poaching
© Cambridge University Press 2009
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Chapter 5 - Objectives
Chapter 5. Learning objectives
• Understand that product differentiation involves
two conflicting forces: it relaxes price
competition, but it may reduce the demand that
the firm faces.
• Be able to distinguish between horizontal and
vertical product differentiation.
• Reconsider the question of entry into product
market.
• Be exposed to some basic approaches to
estimate differentiated product markets.
© Cambridge University Press 2009
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Chapter 5 - Views on product differentiation
Views on product differentiation
• Product differentiation depends on consumers’
preferences.
• Characteristics approach
• Preferences are specified on the underlying
characteristics space
• Discrete choice approach
• Consumers have heterogeneous preferences and choose
one (and only one) product among the available products
• e.g., Hotelling model
• Representative consumer approach
• Consumers are assumed to be identical and have a variable
demand for all products
• e.g., linear demand model with 2 goods used in Chapter 3
© Cambridge University Press 2009
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Chapter 5 - Views on product differentiation
Views on product differentiation
• Discrete choice approach
• Horizontal product differentiation
• Each product would be preferred by some consumers.
• Vertical product differentiation
• Everybody would prefer one over the other product.
• More formally: if, at equal prices,
• consumers do not agree on which product is the preferred
one  products are horizontally differentiated;
• all consumers prefer one over the other product  products
are vertically differentiated.
• Note 1: to account for supply side characteristics, modify the
definition by replacing “at equal prices” by “prices are set at
marginal costs”.
• Note 2: Not easy to draw the distinction in practice
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
A simple location model
• Suppose constant price (e.g., regulated price): p
• Decision for firms: how to position product (where
to locate) in product space (in “linear city”): l1 ,l2 0,1
• Consumers
• Mass 1 uniformly distributed on ; location = ideal
point in product space; linear transportation cost
• Consumers buy at most one unit from one of the firms
• From product i, consumer x derives utility
vi (x)  r   x  li  p
• Indifferent consumer (l1 < l2): x̂  (l1  l2 ) / 2
• Firms’ demands:
Q1 (l1 ,l2 )  (l1  l2 ) / 2, Q2 (l1 ,l2 )  1  (l1  l2 ) / 2
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
A simple location model
• Firms maximize profits w.r.t. their product
location given the location of the competitor

( p  c)(li  l j ) / 2
if li  l j


( p  c) / 2
if li  l j
 i (li ,l j )  

 ( p  c) 1  (li  l j ) / 2  if li  l j
• Unique Nash equilibrium: l  l  1 2
• Lesson: If duopolists choose product locations
1
2
(but do not set prices), they offer the same
product (no differentiation).
• Insufficient differentiation from social viewpoint
• To minimize total transport: l
1
© Cambridge University Press 2009
 1 4 , l2  3 4
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Chapter 5 - Horizontal differentiation
Hotelling model
• Now, firms choose location and price.
• 2 stage model
•
•
1. Location choice (long term decision)
2. Price choice (short term decision)
We already studied (in Chapter 3) the price stage
with extreme locations (i.e., 0 and 1).
We repeat the analysis for any pair of locations
 2 scenarios:
•
•
Linear transportation costs
Quadratic transportation costs
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
Linear Hotelling model
• Consumers
• Mass 1 uniformly distributed on ; location = ideal
point in product space; linear transportation cost
• Consumers buy at most one unit from one of the firms
• From product i, consumer x derives utility
• Firms
vi (x)  r   x  li  pi
• Choose first li in  and then pi
• Constant marginal cost of production, c
• We look for subgame perfect equilibria.
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
• Price stage
•
•
•
Label firms such that l1  l2
If price difference “not too large”, there exists an
indifferent consumer located in [l1, l2]
l1  l2 p1  p2
r   ( x̂  l1 )  p1  r   (l2  x̂)  p2  x̂ 

2
2
What does “not too large” price difference mean?
x̂  l1  p1  p2   (l2  l1 )
x̂  l2  p1  p2   (l2  l1 )
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
• Price stage (cont’d)
•
•
•
What if price difference is “too large”?
Discontinuity in demand:
for p1  p2   (l2  l1 ), no demand for firm 1
for p1  p2   (l2  l1 ), no demand for firm 2
Profits

0

l1 l2
(
p

c)
 1 ( p1 p2 ;l1 ,l2 )   1
2 

( p1  c)


p2  p1
2
© Cambridge University Press 2009

if p1  p2   (l2  l1 ),
if p1  p2   (l2  l1 ),
if p1  p2   (l2  l1 ).
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Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
2 local suprema
  not quasiconcave in p1
Price equilibrium
may fail to exist
Happens when
locations are too
close.
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
• Location stage
•
•
•
Price equilibrium fails to exist for some pairs of
location  no subgame perfect equilibrium
Where price equilibrium exists, firms want to move
towards zone where price equilibrium does not
exist.
Instability in competition
• Lesson: Although product differentiation relaxes
price competition, firms may have an incentive
to offer better substitutes to generate more
demand, which may lead to instability in
competition.
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
Quadratic Hotelling model
• Only difference: transport costs increase with the
square of distance
vi (x)  r   (x  li )2  pi
• Indifferent consumer
l1  l2
p1  p2
r   ( x̂  l1 )  p1  r   (l2  x̂)  p2  x̂ 

2
2 (l2  l1 )
2
2
• Price stage
max p1 ( p1  c)x̂( p1 , p2 ) and max p2 ( p2  c)1  x̂( p1 , p2 )

p1*  c  3 (l2  l1 )(2  l1  l2 )

p  c  3 (l2  l1 )(4  l1  l2 )
*
2
© Cambridge University Press 2009
(unique price equilibrium)
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Chapter 5 - Horizontal differentiation
Quadratic Hotelling model (cont’d)
• Location stage
̂ 1  181  (l2  l1 )(2  l1  l2 )2
̂ 2   (l2  l1 )(4  l1  l2 )
1
18
2

̂ 1 / l1  0 for all l1 [0,l2 )
̂ 2 / l2  0 for all l2 (l1,1]
• Subgame perfect equilibrium: firms locate at the
extreme points  maximum differentiation
• 2 forces at play
• Competition effect  differentiate to enjoy market power
 drives competitors apart
• Market size effect  meet consumers preferences
 brings competitors together
• Balance depends on distribution of consumers, shape of
transportation costs function and feasible product range
© Cambridge University Press 2009
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Chapter 5 - Horizontal differentiation
Quadratic Hotelling model (cont’d)
• Lesson: With endogenous product differentiation,
the degree of differentiation is determined by
balancing
• the competition effect (drives firm to  differentiation)
• the market size effect (drives firm to  differentiation).
© Cambridge University Press 2009
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Chapter 5 - Vertical differentiation
Vertical product differentiation
• All consumers agree that one product is
preferable to another, i.e., has a higher quality
• Consumers
• Quality is described by si [s, s ]  
• Preference parameter for quality:  [, ] 

• larger   consumer more sensitive to quality changes
• Each consumer chooses 1 unit of 1 of the products
• Uniform distribution on [, ], mass M    
• Utility for consumer  from one unit of product i
r  pi   si
© Cambridge University Press 2009
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Chapter 5 - Vertical differentiation
Vertical product differentiation (cont’d)
• Firms
•
•
•
Duopolists
1. Choose quality: s1, s2
2. Choose price: p1, p2
Constant marginal cost, c 
Price stage
•
•
Suppose s1  s2
Indifferent consumer is determined by the ratio of
price and quality differences:
p2  p1
r  p1  ̂ s1  r  p2  ̂ s2  ̂ 
for ̂ [ , ]
s2  s1
© Cambridge University Press 2009
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Chapter 5 - Vertical differentiation
Vertical product differentiation (cont’d)
• Price stage (cont’d)

0

p2  p1
p
 1 ( p1 p2 ; s1 , s2 )   1 s2  s1  

 p1 (   )


if p1  p2   (s2  s1 ),
if  (s2  s1 )  p2  p1   (s2  s1 ),
if p1  p2   (s2  s1 ).
Solving the system of F.O.C.:
p1*  13 (  2 )(s2  s1 )
p2*  13 (2   )(s2  s1 )
(parameter restriction:   2 )
 Even the price of the lowquality firm increases with the
quality difference!
© Cambridge University Press 2009
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Chapter 5 - Vertical differentiation
Vertical product differentiation (cont’d)
• Quality stage
•
Substitute for second-stage equilibrium prices in
profit function:  (s , s )  1 (  2 )2 (s  s )
1
•
1
2
9
2
1
 2 (s1 , s2 )  19 (2   )2 (s2  s1 )
Both profits  in the quality difference  equilibrium
quality choices:
• Simultaneous: (s1 , s2 )  (s, s ) or (s , s)
•
Sequential: 1st (2nd) chooses highest (lowest) quality
• Lesson: In markets in which products can be
vertically differentiated, firms offer different
qualities in equilibrium so as to relax price
competition.
© Cambridge University Press 2009
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Chapter 5 - Vertical differentiation
Case. VLJ industry: “Battle of bathrooms”
• Very Light Jets
• 4 to 8 passengers, city-to-city, 60 to 90-minute trips
You are not
going to have
women on a
plane unless
it has a
lavatory.
Jim Burns,
Founder of Magnum Air
Vertical differentiation
Ed Iacobucci,
CEO of DayJet Corp.
VS
Adam Aircraft A700
More expensive
Has a lavatory
Having a bathroom on board is
not an issue
for short trips.
Eclipse 500
Less expensive
No lavatory
© Cambridge University Press 2009
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Chapter 5 - Vertical differentiation
Vertical differentiation and natural oligopolies
• Analysis of Chapter 4
•
•
•
Natural bounds to number of firms in oligopolistic
markets  main source: scale economies
Number of firms determined by entry process
In the presence of vertical differentiation
•
•
There may be a limited number of firms even for
negligible amount of scale economies.
Intuition from previous model
•
•
•
•
Recall equilibrium prices:
p1*  13 (  2 )(s2  s1 ), p2*  13 (2   )(s2  s1 )
Does not hold if
  2
In that case, if entry cost (however small), low-quality firm
does not enter  natural monopoly
Can be generalized to an n-firm oligopoly (see book)
© Cambridge University Press 2009
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Chapter 5 - Empirical analysis
Probabilistic choice and the logit model
• Discrete choice models
•
•
Important to have consumers choosing differently to
have a ‘smooth’ aggregate demand.
How to formalize this?
•
•
Consumers are heterogeneous by nature.
 assumption made in this chapter (& in most of the book)
Alternative: probabilistic choice theory
 Ex ante (before some random variable is realized):
customers are the same.
 Ex post (after this realization): customers are different
 heterogeneity results from randomness.
 Modelling customer behaviour as probabilistic is
motivated by experimental evidence from the
psychology literature.
© Cambridge University Press 2009
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Chapter 5 - Empirical analysis
Probabilistic choice and the logit model (cont’d)
• Random utility
•
Indirect utility function for a homogeneous good
vi  r  pi   i  vi
•
  i where E i  0
‘Observable’ or
‘measured’ utility
Reflects the preferences of
a subpopulation for good i
in expectation
Binary discrete choice model
•
•
•
Consumers face 2 alternatives, 1 and 2
Denote ei the realization of i
Choose alternative i if
vi  v j  e with e  realization of   1   2 , and E  0
© Cambridge University Press 2009
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Chapter 5 - Empirical analysis
Probabilistic choice and the logit model (cont’d)
• Binomial logit
•
•
•
Assume that  is logistically distributed
F(e)  1 / [1  exp{e / }]
Probabilistic demand is then of the form
1
exp{v1 / }
Q1 

1  exp{(v1  v2 ) / } exp{v1 / }  exp{v2 / }
Multinomial logit
•
Extension to n products
Qi 

exp{vi / }
n
j 1
exp{v j / }
© Cambridge University Press 2009
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Chapter 5 - Empirical analysis
Empirical analysis of horizontal differentiation
• Demand side
•
•
Consumers can choose among n products (+ an
outside good, noted 0, with utility = 0)
Market shares using multinomial logit (with )
i 
•
exp{vi }
1   j 1 exp{v j }
n
All consumers have the same mean utility level
vi   xi  i   pi
Vector of observed
characteristics
mean utility derived from
unobserved characteristics
© Cambridge University Press 2009
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Chapter 5 - Empirical analysis
Empirical analysis of horizontal differentiation
• Demand side (cont’d)
•
•
•
Linear market shares in unobserved characteristics:
logi  log  0   xi  i   pi
If we consider i as an error term, we can estimate
demand parameters () from this structural
model.
Supply side
•
•
Nash equilibrium in prices
ci   wi   i
Costs:
Relevant observable product
characteristics on the cost side
mean cost derived from
unobserved characteristics
© Cambridge University Press 2009
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Chapter 5 - Empirical analysis
Empirical analysis of horizontal differentiation
• Estimation of the model
•
•
Firm i’s profits:  i  ( pi  ci )M  i
From F.O.C.:
pi  ci 
•
i
 i / pi
  wi 
 i / pi
  i   wi 
1
i
  i / vi
Using multinomial logit:
pi   wi 
•
i
1
1
 i
 1  i
Can be jointly estimated with
logi  log  0   xi  i   pi
© Cambridge University Press 2009
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 i
Chapter 5 - Empirical analysis
Extension: the nested logit model
• Limitations of the logit model
•
Restrictions are imposed on substitution patterns.
•
•
•
May be unrealistic
Example: product introduction in the family van segment
has different effects on the market share of a car in that
segment or on an SUV.
Possible answer: nested logit model
•
•
Group different products together in different nests.
Consumers select first among nests and then within
the selected nest.
© Cambridge University Press 2009
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Chapter 5 - Review questions
Review questions
• In which industries is product differentiation
important? Provide two examples.
• What makes firms locate close to each other in
the product space? And what does it make them
to differentiate themselves from their
competitors?
• When is vertical product differentiation present in
an industry? Discuss demand and cost
characteristics.
© Cambridge University Press 2009
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Chapter 5 - Review questions
Review questions (cont’d)
• Does the number of firms in an industry with
constant marginal costs necessarily converge to
infinity as the entry cost turns to zero? Explain.
• Why are we interested in empirically estimating
models of product differentiation? (After all, to
understand the intensity of competition in the
short run, we only need to know the Lerner
index.)
© Cambridge University Press 2009
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Part III. Sources of market power
Chapter 6. Advertising and related marketing strategies
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2009
Chapter 6 - Objectives
Chapter 6. Learning objectives
• Understand to what end and to what effect firms
devote resources to advertising.
• Be able to distinguish between the different
views on advertising: informative, persuasive
and complementary advertising.
• Understand how a monopolist chooses
advertising expenditures and how this choice
affects welfare.
• Understand how advertising decisions are made
in oligopoly settings and how they affect price
competition.
© Cambridge University Press 2009
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Chapter 6 - Some statistics
Case. U.S. spending on advertising
(Data from AdvertisingAge, June 2007)
47%: marketing services
53%: media spending
© Cambridge University Press 2009
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Chapter 6 - Some statistics
Case. U.S. media spending on advertising
(Data from AdvertisingAge, July 2009)
© Cambridge University Press 2009
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Chapter 6 - Some statistics
Case. U.S. media spending on advertising (cont’d)
(Data from AdvertisingAge, July 2009)
© Cambridge University Press 2009
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Chapter 6 - Views on advertising
Why do consumers respond to advertising?
• 1st view: advertising is persuasive
• It alters consumers’ tastes.
• It  product differentiation & consumers’ loyalty.
• Likely effects (to be confirmed)
• Demand becomes less elastic; prices ; entry becomes
more difficult; welfare .
• 2nd view: advertising is informative
• It conveys information about existence, prices and
characteristics of products (directly or indirectly).
• Likely effects (to be confirmed)
• Demand becomes more elastic; prices ; welfare .
© Cambridge University Press 2009
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Chapter 6 - Views on advertising
Why do consumers respond to advertising?
(cont’d)
• 3rd view: advertising is complementary
• Complementary to the advertised product.
• It enters into the consumer’s utility function, in
complement with the product itself.
• Idea: consumers consumes ‘social images’ by combining
products and advertising.
• Likely effects (to be confirmed)
• Similar to persuasive view.
• Yet, it may be beneficial
through its direct valuation
by the consumers.
Having a Louis Vuitton bag may allow you to look as cool
as Sean Connery if (1) you actually possess such a bag
and (2) the ad links the bag to the cool attitude that you
want to project in your relevant peer group.
© Cambridge University Press 2009
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Chapter 6 - Views on advertising
How to distinguish the 3 views empirically?
• Classify advertising spots
• Possible to identify directly informative advertising.
• Much harder to separate indirectly informative and
persuasive advertising.
• Find industries subject to a shock and analyze
the effect of advertising on market outcomes
• E.g., a certain type of advertising becomes (il)legal
• Look at implied purchasing behavior
• Informative advertising is valuable for inexperienced
consumers but not for experienced consumers.
• Persuasive & complementary advertising affect both
types in the same way.
• Testable hypothesis: informative advertising affects
demand of inexperienced consumers more strongly.
© Cambridge University Press 2009
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Chapter 6 - Views on advertising
Case. Yoplait 150
• Data
• Yoplait 150: 1st low calorie, low fat yogurt, introduced
into the US market in 1987.
• Scanner data collected at Sioux Falls, South Dakota
and Springfield, Missouri (about 4,000 households)
• Weekly prices at drugstores and supermarkets over
three years (1986-1988).
• A.C. Nielsen TV meters: household TV advertisement
exposures.
• Main result
• Advertisement affects initial purchases much more
than repeat purchases.
• Supports the view that advertising was predominantly
informative in the Yoplait 150 case.
© Cambridge University Press 2009
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Chapter 6 - Advertising in monopoly
Price and non-price strategies in monopoly
• Dorfman-Steiner model
• Include non-price variable into monopoly problem: firm
chooses price, p, and advertising expenditure, A.
• Demand: Q(p,A) with Qp  and QA  consumers
respond to more advertising by increasing demand)
• Monopoly’s problem: choose p and A to maximize
( p, A)  pQ( p, A)  C(Q( p, A))  A

p  C
Q
1
 ( p  C  )Q p  Q  0 


p
p
pQ p Q, p

p  C
1 1
Q A
1 A
 ( p  C  )QA  1  0 



A
p
QA p AQA pQ Q, A pQ
with Q, A  advertising elasticity of demand
© Cambridge University Press 2009
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Chapter 6 - Advertising in monopoly
Price and non-price strategies in monopoly (cont’d)
• Dorfman-Steiner model (cont’d)
• Equating the 2 previous values:
1
Q, p

1
Q, A
A

pQ
Advertising expenditure / revenue
 Advertising intensity
A
pQ

Q, A
Q, p
Advertising elasticity of demand /
Price elasticity of demand
• Lesson: A monopoly sets its advertising
intensity to the ratio of the advertising elasticity
of demand over the price elasticity of demand.
© Cambridge University Press 2009
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Chapter 6 - Advertising in monopoly
Price and non-price strategies in monopoly (cont’d)
• Closer look at how advertising affects demand
• Persuasive advertising
•
•
•
•
•
•
•
•
Continuum of consumers of mass equal to 1
Each consumer buys at most 1 unit of monopolist’s product
Heterogeneous valuation:  uniformly distributed on 
Persuasive advertising ‘inflates’ consumers’ valuations
 willingness to pay: g(A), with g()  and g’(A) 
At price p, consumers who buy are such that p g(A)
Hence, demand is Q(p,A)  p g(A)
Price-elasticity: Q,p  p g(A)  p)
 with A as g’(A)  more advertising makes demand less
elastic, as predicted by persuasive view.
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Chapter 6 - Advertising in monopoly
Price and non-price strategies in monopoly (cont’d)
• Closer look (cont’d)
• Informative advertising
• N consumers, with same decreasing demand function, d(p)
• Initially, all consumers are unaware of the product; they are
made aware if they receive an ad.
• Monopolist sends A advertising messages.
• Same probability for each consumer to receive a message
• Probability of not receiving an ad (for N large): eA/N
• Hence, demand is Q(p,A)  eA/N) d(p)  G(A) d(p)
• Note: G’(A)  G’’(A)
• Price-elasticity: Q,p  p d’(p) / d(p), insensitive to the number
of advertising messages: more advertising does not make
demand less elastic, as predicted by informative view.
© Cambridge University Press 2009
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Chapter 6 - Welfare effects
Some welfare effects of advertising
• Is advertising socially desirable?
• We study the issue in the previous monopoly model
•
•
•
•
Starting point: monopoly solution, (pm, Am)
Change advertising to some nearby level A
Monopolist reacts with profit-maximizing price pm(A)
Compute change in welfare, where welfare is defined by
r( A)
W ( p, A)  ( p, A) 
 Q( p, A)dp,
p
with r(A) satisfying Q(r(A), A)  0.
Maximum price consumers are
willing to pay (may vary with A)
© Cambridge University Press 2009
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Chapter 6 - Welfare effects
Some welfare effects of advertising (cont’d)
• We want to evaluate

If advertising  monopoly price, it 
consumer surplus and thus, welfare.
Additional consumer surplus that
advertising generates on the inframarginal units because of the
demand shift.
Negative or positive effect
Positive effect
Net effect ?
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Chapter 6 - Welfare effects
Some welfare effects of advertising (cont’d)
• Lesson: If additional advertising does not cause
the monopolist to raise its price, then the
monopolist will supply too little advertising.
But if it does, then it induces 2 conflicting effects
on welfare and the net effect is ambiguous.
• Effect of additional advertising on price?
• Depends on the nature of advertising and on the
monopolist’s cost function.
• Informative advertising: monopoly advertising is socially
insufficient if marginal cost is constant or decreasing.
• Persuasive advertising: even if advertising  monopoly price,
monopolist may provide too little advertising.
© Cambridge University Press 2009
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Chapter 6 - Advertising and competition
Does advertising toughen or soften competition?
• Advertising can play 2 roles
• “Constructive” role
• Informs consumers about existence, characteristics and
price of products
 ambivalent effect on price competition
• Or:  perceived differences between brands
 likely to soften price competition
• Combative role
• Helps firms steal each other’s business
 likely to toughen price competition
• This general intuition needs to be confirmed by
looking at specific market settings.
© Cambridge University Press 2009
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Chapter 6 - Advertising and competition
Informative advertising
• Intuition
• In monopoly, more informative advertising  more
informed consumers  more profits
• In oligopoly, more informative advertising  more
informed consumers about several products  more
intense competition  more or less profits?
• Model: extension of Hotelling model
• 2 firms located at extreme points of 
• Mass 1 of consumers uniformly distributed on 
• Utility of consumer x (assuming linear transport costs):
r   x  p1 if she buys 1 unit of good 1,
r   (1  x)  p2 if she buys 1 unit of good 2.
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Chapter 6 - Advertising and competition
Informative advertising (cont’d)
• Demands
• Only a share i of consumers know about the
existence of product i.
• Probability of being informed: independent of location
• 3 types of consumers
• Fully informed  share i j  indifferent consumer:
r   x̂  p1  r   (1  x̂)  p2  x̂  12  21 ( p1  p2 )
• Partially informed (know good i only)  share i (j )  buy if
r    pi  0 (suppose r large enough, so OK)
• Uninformed  share (i ) (j )  don’t buy
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Chapter 6 - Advertising and competition
Informative advertising (cont’d)
• Demands (cont’d)
Q1 ( p1 , p2 , 1 , 2 )
 1 (1  2 )  2 x̂( p1 , p2 )
 1 (1  2 )  2 21 (  p1  p2 ) 
More informative advertising
from both firms
 larger share of fully
informed consumers
 larger price elasticity of
demand
© Cambridge University Press 2009
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Chapter 6 - Advertising and competition
Informative advertising (cont’d)
• Equilibrium analysis
• Firms simultaneously set prices and number of ads
• To inform share i of consumers (about existence, price,
characteristics of good i), firm incurs
• Firms’ program
A(i )  ai2 / 2
max( p1  c)Q1 ( p1 , p2 , 1 , 2 )  A(1 ); similarly for firm 2
p1 , 1
• FOCs
 1
 1 (1  2 )  2 21 (  2 p1  p2  c)   0
p1
p  c   1  2
 p1  2


2
2
Higher price than
under full information
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Chapter 6 - Advertising and competition
Informative advertising (cont’d)
• Equilibrium analysis
• FOCs
 1
 ( p1  c) (1  2 )  2
1
 1 
1
2
(  p1  p2 )   a1  0
1
( p1  c) (1  2 )  2
a
1
2
(  p1  p2 ) 
• Symmetric equilibrium
p*  c   1   *
2  *
*
p 

  p  c

*
*
2


*
1
1
2


*
* 1


 *  ( p*  c) (1   * )   * 12  

(1


)


2
*

a
a 
*
2
2a
*
*
 
, p  c  2a ,  
1  2a / 
1  2a / 
*

© Cambridge University Press 2009

2
55
Chapter 6 - Advertising and competition
* 
Informative advertising
• Observations
2
2a
, p*  c  2a ,  * 
1  2a / 
1  2a / 

• Higher price than under full information (a  p
*
c)
• Why? Lower elasticity of demand  higher markup
• More product differentiation ( )  higher prices
• Stronger effect than under full information
• Lower advertising cost (a )  lower prices
• Why? a   advertising   more informed consumers
 more competition  prices 
• Amount of advertising  when a  or  
• Profits increase as advertising becomes more costly
• Why? Negative direct effect (higher costs) more than
compensated by positive strategic effect (lower share of
informed consumers   less intense competition)
© Cambridge University Press 2009
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
2
Chapter 6 - Advertising and competition
Informative advertising (cont’d)
• Lesson: Due to strategic effects of informative
advertising, higher advertising costs translate into
more market power  Firms’ profits can be
higher in a market with higher advertising costs.
• Applications
• Testable hypothesis: Internet search engines  lower
advertising costs  lower profits?
• Industry lobbying in favor of advertising restrictions?
• High a seen as collusive device
• Advertising restrictions self-imposed by certain professions
(e.g., lawyers, accountants)
© Cambridge University Press 2009
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Chapter 6 - Advertising and competition
Persuasive advertising
• Intuition
• In monopoly, more persuasive advertising  outward
shift of demand  more profits
• In oligopoly, does the increase in one firm’s demand
come at the expense of another firm’s demand?
• Yes  shift of demand between brands  business stealing
 advertising may be excessive (prisoners’ dilemma)
• No  global demand expansion  advertising may be
insufficient (public good nature)
• Modelling: 3 extensions of Hotelling model
• Advertising increases willingness to pay
• Advertising changes distribution of consumer tastes
• Advertising increases perceived product differences
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Chapter 6 - Advertising and competition
Persuasive advertising (sketch; see details in book)
• Advertising  willingness to pay
• Utility of consumer x (with i = advertising intensity)
r  1   x  p1 if she buys 1 unit of good 1,
r  2   (1  x)  p2 if she buys 1 unit of good 2.
• Advertising changes distribution of tastes
• Symmetric distribution function
F(x; 1, 2 )  (1  1  2 )x  (1  2 )x 2
• Lesson: In both cases, advertising expenditures
are simply a form of wasteful competition: if firms
could cooperate, they would agree not to
advertise.
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Chapter 6 - Advertising and competition
Persuasive advertising (sketch cont’d)
• Advertising  perceived product differences
• Advertising intensities affect degree of product
differentiation (i.e., transport cost):
 (1 , 2 )    1  2
• Lesson: Here, firms invest in advertising to relax
price competition and, thereby, achieve higher
profits. Because advertising is a public good,
firms would even be better off by coordinating
their advertising decisions.
© Cambridge University Press 2009
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Chapter 6 - Advertising and competition
Case. Promotion of private healthcare
www.privatehealth.co.uk/news/december-2005/advertising-dec05-104/
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Chapter 6 - Review questions
Review questions
• Which industries advertise a lot? Give two
examples and discuss the likely reasons for high
advertising expenditures.
• Discuss the difference between persuasive
advertising and advertising as a complement.
• Consider informative advertising about a
product’s existence. Does an increase in the
advertising cost function necessarily lead to
lower profits? Discuss.
• Discuss possible effects of persuasive
advertising under imperfect competition.
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