Advertising and Competition. Andrew V. Abela. and. Paul W. Farris

Transcription

1 Advertising and Competition By Andrew V. Abela and Paul W. Farris December 15, 1999 Darden School of Business Administration University of Virginia PO Box 6550 Charlottesville, Virginia Tel

2 Advertising and Competition ABSTRACT. What is the impact of advertising on competition, and hence on price? In this chapter we provide a critical review of the recent literature on advertising effectiveness, market efficiency and advertising and price. We conclude that focus needs to shift to absolute, not relative, prices, and that the role of vertical competition needs to be recognized explicitly. Does advertising increase or decrease competition? Our purpose in this chapter is to advance the understanding of this question, and particularly the impact of advertising on price, by critically reviewing recent research, adding some new insight, and identifying areas for future research. The main conclusions that we draw are that research should focus more on absolute price levels than on relative price differences (price dispersion) and that the significant impact of distribution policy on price needs to be examined more closely. Accordingly, the chapter is divided into four sections. In the first section, we lay out the question, provide some in-going assumptions and definitions, and set the scope for the discussion. In the second section, we summarize the opposing views that typically define debate around the question. In the third section, we provide a critical review of recent work on this question, as well as some additional research that we think brings additional, important perspective. In the final section, we present our own conclusions about the question, and identify areas for future research. The question Interest in the question of the impact of advertising on prices often starts with the observation that companies with relatively higher advertising budgets also usually charge 1

3 higher prices. Consumers are willing to pay higher prices for a number of reasons that include advertising, as well as superior product quality, better packaging, more favorable user experience, market position, and warranty and/or service. When these latter, nonadvertising, factors are assumed equal, we can ask why consumers can be expected to generally pay more for the advertised products. This is a question that invites all sorts of speculation: the implied confidence of manufacturers that are willing to advertise, mere familiarity or reminder effects, and even the psychic value of lifestyles associated with advertised brands. We claim no particular insight into these reasons, but we do find it difficult to believe on the other hand that consumers would be willing to pay more for a product whose sole distinction is that it is unadvertised. Therefore the fact that advertised products tend to have higher prices is not very significant, since the opposite is highly unlikely (Farris and Reibstein 1979; 1997). On the other hand, what conclusions about levels of competition and of absolute retail prices in a market or category can we draw from the observation that prices of advertised brands are usually higher than those of nonadvertised, functionally equivalent products? And why might such differences exist? In particular we seek to expand the scope of the discussion to recognize that there are three important groups of actors: consumers, manufacturers, and retailers. We believe that understanding the effect of advertising on consumers price sensitivity (although a significant challenge) would not be enough to definitely answer the question of whether advertising, ultimately, makes products more expensive. We need to integrate our knowledge of these effects with assumptions and models of manufacturer (sellers) and retailer (middlemen) behavior. As retailers, manufacturers, and consumers react to each other, there is no problem in running out of fresh material in this investigation. 2

4 These interactions create new pricing and promotional strategies, such as yield management, which are more sophisticated methods for delivering targeted discounts. Technology is an enabler of these new strategies, as is the predicted rapid growth of the friction-less Internet economy (e.g., bots that search the Web for low prices), which adds further complication to the question. We begin by providing three important assumptions and some definitions of price that will help establish the scope of this discussion. Assumptions The impact of advertising on price competition and hence on price is part of the much larger network of effects that determine the degree to which commercial advertising is socially beneficial. We make three assumptions to simplify these effects for the purpose of our analysis. Assumption 1: Products are only imperfect substitutes. When we speak of competition in this chapter, we do not have in mind the economic concept of perfect competition (an equilibrium condition under which marginal profits equal marginal costs and no manufacturer or supplier has the freedom to raise prices). Instead, we start from the assumption that products are only imperfect substitutes and that most manufacturers and retailers enjoy some limited product differentiation, market power, or other advantage that gives them realistic pricing options. In other words, there is some variation in prices that may result in higher or lower sales volume, but these variations are within the operating range of the company. The whole notion of price comparisons would be rendered invalid if we were to assume, however, that every product was so different as to justify whatever price differences were 3

5 observed. We also need to recognize that each purchase is made at a unique point in time and space and that some different utility is associated with that timing and location. A cold soft drink is worth more on a hot day at a ballpark than on a cold day in a warehouse club store. Unlike classical markets, we accept that imperfect competition results in a certain amount of price dispersion for functionally equivalent products. We need to find ways to make sense of this level of dispersion. Assumption 2: Resellers play an important role in stocking and promoting the product Given this assumption, our focus is on analyzing advertising s influence on the marketer s ability to raise prices without losing appreciable percentages of sales volume (price inelastic), or to gain large increases in sales by only lowering price by a small amount (price elastic). Under different circumstances, either of these options would look good to marketers. Interestingly, the same product can provide both opportunities at different levels in the value chain at a particular point in time. As an example, take a leading product such as Tylenol that most retailers would agree absolutely had to be in stock. An increase in the price of this product to all retailers is not likely to cause much change in volume sold by all retailers in the short term. A temporary change in the retail price of the product by a single, highly visible, retailer, however, could lead to significant volume change for that particular retailer in the near term, if brand switchers were drawn to it and loyal consumers stocked up (or vice versa). Tylenol would then be said to be price inelastic at the manufacturer level and price elastic at the retail level. If the price decrease were perceived by consumers to be permanent, however, then it is less likely that stocking up would occur. Thus temporary price variations are part of the landscape as well. Indeed, retailers often resort to devices such as clearance sales, going out of 4

6 business sales, and the like to communicate to consumers that the low prices are a temporary phenomenon and that consumers should buy now. Assumption 3: Quality levels already established The third assumption in our analysis of advertising-price relationships is that quality levels and product differences have already been established and thus are stable. We recognize that in reality these are always changing and that advertising has an essential role in communicating such changes. Over the long-term, the incentive to invest in research and development activities that improve product quality and to invest in advertising and promotion programs that bring these innovations to market cannot be completely separated from the ability to use advertising to command higher prices and profit margins. The long-term role of advertising must include the ability of advertising to stimulate new product investments. It may do this by improving the new product introduction process and the diffusion of innovation as well as by providing margins and incentives to invest in marketing and R&D. If innovators could not capture the fruits of their new ideas and risk-taking activities then the innovation process would suffer. Advertising, especially mass advertising, is helpful for introducing new products quickly and in a way that enables the innovator to capture value. Even if profit margins at any given time are too high, we must also consider whether the market system that produced these margins is at the same time encouraging the development and introduction of innovative new products. Certain inefficiencies in finding the lowest price for given quality level are arguably compensated for if the overall result was a productive process of replacing obsolete products. 5

7 Premium price strategies create margins that are available to invest in the risky activities of funding R&D projects and launching new products. These prices and margins compensate for the failed innovations as well. To ignore the uncertainties in this process would be to fundamentally misapprehend the management decision process concerning budgets for both. Although this is an essential part of the dynamic process that results in higher advertising and higher prices for certain products, the scope and focus of this chapter compels us to make the strong assumption that quality levels have already been established. Price comparisons are only meaningful when they are made among items of similar quality, or among the same items sold at different times or in different markets. Definitions Measuring prices sounds simple enough, but quickly is complicated by the need to distinguish between different kinds of prices. We therefore provide definitions of some of the different kinds of prices that we believe are important and yet often overlooked. For the purpose of this discussion, manufacturer price is the manufacturer s selling price, and, except in situations where there are intervening parties such as distributors, this price is usually the retailer s purchase price. Retail price is the retailer s selling price, and as used here is synonymous with the consumer s purchase price. Relative price is the ratio between the price of the cheapest brand versus the most expensive brand (measured either in retail or manufacturer prices) among functionally equivalent products. To distinguish from relative price, we use the term absolute price, which we use to denote the mean of the prices of all such brands (weighted by share of sales). Such an absolute price assumes that we are able to calculate the average price per 6

8 statistical unit across different sizes, forms, and other product variations in a meaningful way. Price range is the difference between the highest and lowest prices available for the functionally equivalent products. There are other more developed measures of price dispersion (see Brynjolfsson and Smith 1999), but for a non-empirical discussion, simple differences will suffice. Any empirical examination of these prices also has to deal with the problem of coupons, rebates, manufacturer allowances, and shipping/transportation costs. These complications can confuse measurement. In the extreme, retailers may not be sure of their own selling price (for example, when retailers offer to triple the value of manufacturer coupons) or even purchase price (such as when manufacturer rebates are grouped across product lines or not available until the end of period and contingent upon sales goals). By functionally equivalent products we mean products which are identical in their functional capabilities with regard to normal use, and hence substitutable in the eyes of the consumer who cares only about functional benefits (however difficult this kind of equivalence may be to determine in practice). At the same time, though, we maintain that such a consumer is not necessarily the typical consumer, and that benefits beyond purely functional product benefits can have a significant effect on consumer choice, and therefore serve as a basis for differentiation. A recent survey of consumer purchasing habits for automobiles and for cosmetics conducted for McKinsey & Co., for example, indicates that in each case a sizable segment of consumers values benefits arising from the process of acquiring the product and from their relationship with the company more than the product s functional benefits. These segments were 19% of the automotive buyers and 43% of the cosmetics buyers in the survey (Court et al. 1999, p. 9). 7

9 Scope of inquiry We recognize that there are potential effects of advertising at the macro level, both positive and negative, such as driving the growth of new industries or creating a culture of consumption. We also note that the desirability of any given product will always be dependent upon the existing technological, political and cultural environment and that advertising seems to be firmly entrenched as part of our culture. Advertising practices are always evolving and today, there may be more concerns with the idea of how strong brands are priced than with advertising per se. There are other methods of building brands with non-traditional media, such as sponsorships and point-of-purchase promotions. Limiting tobacco advertising does not seem to have hurt Marlboro, for example. Indeed some firms fear that the absence of advertising will increase the brand s dominance. The use of the Web to promote brands will undoubtedly become more important and probably more difficult to regulate. Nevertheless, we limit our exploration to the micro level, and particularly to those situations where there are no radical technological shifts or new competitors entering. All these complications we assume away to sharpen our focus. Within the scope of our inquiry, we are primarily interested in whether advertising results in consumers paying higher prices that they otherwise would pay (see Exhibit 1). This is related to, but not exactly the same as the notion of an efficient market as defined by Ratchford et al. (1996): a market where actual or potential losses to individual consumers, which results from imperfect information about alternatives are or can be large. The imperfect information is about prices and qualities of alternatives. {Insert Exhibit 1 Here} 8

10 Opposing views Economists have long used two principal models to describe the effects of advertising on price paid, the results of which appear to contradict one another. In the Advertising = Market Power model, advertising is thought to influence consumer tastes, establish brand loyalty, and ultimately raise profits and consumer prices by decreasing price sensitivity and competition. In the Advertising = Information model, advertising is seen as providing information to consumers, resulting in increased price sensitivity, lower prices, and reduced monopoly power (Farris and Reibstein 1997). Both models have provided important contributions to the discussion, and both still have their followers. Market Power Model Proponents of the market power model argue that advertising too often creates the impression of higher quality where marginal or no product differences exist. There is little doubt that in many cases marketers attempt to justify price premiums and escape the intensity of price competition by using advertising to communicate marginal product benefits to consumers. Some brands, such as Absolut vodka, would not likely be able to charge their current prices without the support of advertising. Vodka is tasteless, colorless and odorless, which makes it difficult to find characteristics on which to differentiate. (Vodka manufacturers thus typically compete on purity : i.e. our product is more tasteless, colorless and odorless than the competition! ) Perhaps a classic case is Extra Strength Tylenol, which was built on the claim You can t buy a more potent pain reliever without a prescription. Strictly speaking, the claim is only one of parity performance, asserting that no stronger product exists, and making no comment whether 9

11 there are any other products which are equally strong and in fact there are several. Yet the brand grew steadily with the help of this advertising claim (Strenio 1996). Information Model Proponents of the information model argue that our ability to determine whether there really are no differences among products is suspect, and that we are better off to allow consumers to make their own decisions. This model argues that advertising makes consumers aware of alternatives, and tries to highlight product quality differences that may not be otherwise apparent, to the extent that this is possible. For example, to overcome the difficulties of advertising vodka which were noted above, Gray Goose vodka advertised the results of an expert panel which gave their product the highest marks in taste tests that included Absolut and several other brands. By becoming more aware of viable alternatives increasing their evoked set consumers can become more price sensitive (Mitra and Lynch, 1995). At the same time, by making real product differences more clear, manufacturers can lead consumers to pay more for a product when they recognize its unique benefits. Complications In addition to the fact that the implications of the two models presented oppose each other, there are several other complications with the current understanding of the advertising and price debate. First, there are several, and somewhat contradictory, ways of understanding the causal relationship between advertising and price. Second, there is significant difficulty in estimating the relationship between advertising and price premium. Third, brand loyalty has ambiguous implications. Fourth, and finally, the impact of the Internet promises to add significant additional complexity. 10

12 Causal relationships. Two popular views see the direction of causality flowing from advertising to higher prices. The first view is that advertising is a cost. As such, firms that advertise must charge higher prices to cover this cost. Further, it is argued, if advertised were eliminated then consumer prices could be reduced by the percentage of sales that advertising constitutes (which is about 2 to 3 percent for a wide variety of products, but as much as 30 to 40 percent for some). Marketers themselves implicitly buy into this argument when they look at advertising and price promotion as competing for a share of marketing budgets instead of as complements. In the extreme, there is some truth in this view. The second causal view also runs from advertising to prices. Most marketers, we assert, believe that higher advertising will enable them to charge higher prices (to some degree). While some marketers might argue that it is higher quality that gives advertisers something to say in the advertising to justify higher prices, it need not always be the case that highly advertised products have superior quality. This is particularly true if the superior quality is either not easily perceived or easily believed (see Borden 1942). Advertising, in this view, shifts the demand curve out (more volume sold at all possible prices) and may change the slope of the demand curve, making demand less responsive to price at higher prices. Firms with high advertising expenditures may have more options, but even these firms expect lower sales volumes for higher prices. High advertisers also must find the combination of prices and volumes that maximizes (or satisfices ) total profits. 11

13 An alternative causal view presents the opposite direction of causality: that higher prices cause higher advertising by increasing the amount that marketers are willing to pay for an incremental sale. The key intervening variable is gross profit margin. Empirically, it has been found that gross profit margins (before marketing and other fixed costs) are the single most important predictor of higher advertising-to-sales ratios among cross-sections of firms and businesses (Buzzell and Farris 1977; Farris and Albion 1981; Farris and Buzzell 1979). Of course, higher gross profit margins can also result from lower costs of distribution or production. Therefore, we believe that, all else equal, the firm with lower costs will usually advertise more as percentage of sales. Clearly, the pricing and advertising decisions cannot be easily separated, even for functionally equivalent products. As joint decisions that affect each other, the causality is difficult to conceptualize and does not lend itself to simple empirical tests (Dorfman and Steiner 1954; Farris and Reibstein 1979; 1997). Advertising and price premium relationship Even for specific brands, it can often be difficult to tell how advertising works on price premiums and sensitivity to price differences. For example, Quelch (1986) reports the results of a GE experiment on advertising for light bulbs. After GE aired advertising which emphasized the benefits of their soft white bulbs, the percentage of consumers who rated these bulbs as very good value increased at double or more than the increase for competitive brands, when the GE bulbs were priced at parity to competitors. When the GE bulbs were premium priced, their value rating still increased after this advertising, although only marginally, while when the competitor bulbs were premium priced their value ratings declined (p. 408). The implications of such a relationship between 12

14 advertising and price-premium are not clear-cut, although the marketer could sell more at the higher price, the parity price is relatively more attractive after the advertising than before. Brand loyalty Brand loyalty for the manufacturer can also result in higher or lower price sensitivity, depending on the time frame, on the types of prices, and on whether demand shifts are measured across or between retailers. A brand loyal consumer is not necessarily less price sensitive. A distinction needs to be made between price differences among different brands and price differences in the same brand over time. Imagine the reaction of two consumers faced with a sale on a product. One is very brand loyal to this product and the other is not. Which consumer is likely to buy more of this product while on sale (and thereby appear to be more price-sensitive)? We assert that the brand loyal consumer will likely buy more, because the non-loyal one is happy to buy whatever goes on sale next week, while the loyal one will stock up while the brand is on sale. In this way brand loyal consumers can appear to be more price sensitive, at least to price differences for the same brands from week to week and from retailer to retailer. However, the same loyal consumer might continue to buy the brand if prices relative to other brands were increased. We ask the reader to consider which price sensitivity is being measured with weekly or daily scanner data on sales and prices. Impact of the Internet The question of the impact of advertising on price developed and evolved through an era when the basic issues were defined in terms of the physical shipment of products and their promotion through periodic price reduction events. This question would appear 13

15 to become more complicated and interesting with the growth of Internet commerce. The promise of friction-free transactions adds a new dimension to the problem, while also providing the opportunity for new insights (which we will take advantage of in our discussion on market efficiency below). No simple model explains all of the evidence. Critical review of recent research Several recent empirical generalization studies, or meta-analyses, have summarized the findings from the substantial number of studies relevant to our question: Vakratsas and Ambler (1999), and Lodish et al. (1995), on advertising effectiveness; Ratchford et al., (1996), on market efficiency; Mitra and Lynch (1995) and Kaul and Wittink (1995) on advertising and price. We discuss each of these in turn, along with selected individual studies. Understanding the effect of advertising on price is complicated by the fact that after 100 years of research we are still not sure exactly how the effects of advertising occur. Beginning with the first formal advertising model in 1898, advertising has been primarily explained using hierarchy of effects models. However, these have recently been seriously questioned. Hierarchy of effects models propose that advertising works through a determined series of effects: first gaining attention, for example, then peaking interest, then creating desire and finally motivating action. Yet Vakratsas and Ambler s (1999) review of 250 journal articles on how advertising affects consumers concluded that there is little support for such hierarchy of effects models. Lodish et al s (1995) meta-analysis of 389 split-cable TV advertising experiments between 1982 and 1988 also emphasizes how little we know about what makes advertising work. While conventional wisdom holds that more advertising leads to more sales, they found no obvious 14

16 relationship between the magnitude of a weight increase [in advertising] and the significance of the impact on sales (6). They found that the data explain less than half of the variance in sales changes associated with TV advertising weight changes (18). These two studies would seem to call for a major re-thinking of our approaches to understanding the effects of advertising. This re-thinking would therefore include our approaches to understanding the impact of advertising on price competition. Market efficiency Part of the difficulty with the debate on the effect of advertising on price has been that until recently there was no comprehensive theoretical framework to address consumer welfare aspects of pricing. Ratchford et al. (1996) make a significant contribution conceptualizing this problem by proposing a theoretical model to integrate existing findings. The focus is on determining measures of market efficiency, defined in terms of actual or potential losses to individual consumers (p. 168) resulting from imperfect information about alternatives. They review the several different measures of market efficiency that have been used in previous studies: price-quality correlations; measures based on a frontier relation between prices and characteristics, and price dispersion. They relate each of these to a model of economic welfare, and determine that while the first two measures have serious limitations, 1 price dispersion does measure the variance in consumer surplus in this model when there is no variance in quality. Recognizing further limitations, they still conclude that the large order of magnitude of efficiency estimates observed in many markets across many studies makes it hard to avoid the conclusion that consumers are often presented with the opportunity to pay higher prices than they need to for a given quality and that many probably do so (p. 177). 15

17 We would argue, however, that the use of price dispersion relative price rather than absolute price to measure the impact of prices on consumer welfare is problematic. Ratchford et al. allow that measurements of market efficiency (including price dispersion) do not take into account the different kinds of value added offered by different retail outlets: Retailer services can enhance utility and should be counted though they rarely are in published data such as the Consumer Reports data employed in many studies of market efficiency (p. 172). Extending the model proposed by Ratchford et al. to include space/time utility, we believe, is a critical next step. Consumers are typically willing to pay a higher price for the identical item from a different retailer because of greater convenience in place or time, for example, or even because the shopping experience is more pleasant. Many varieties of products are available at different times and places where they might not otherwise be without the higher margins required to support them. Aspirin comes in various dosage sizes, coatings, forms (capsules, tablets, caplets, liquid), and package counts. These variations and their potential importance to different segments mean that we need to develop a theory of price dispersions that take into account the opportunity that consumers have to purchase products at various prices. Assume, for example, that a small shop in an airport decides to add aspirin to the assortment of other products sold. Such a shop is likely to charge higher prices and margins than most other retailers. Airport shops are able to do this, not because headaches are more severe in airports, but because they have local monopolies. Higher income customers for whom time is a premium are also part of the equation. We do not believe consumers, in the aggregate, are worse off because they 16

18 now have this additional opportunity to purchase aspirin. Yet both the average purchase price and dispersion of prices will likely increase. The studies in Ratchford et al. measure price dispersion of physically identical items across different outlets in a given retail market (p. 168). Physically identical clearly means items that are physically functionally identical; this includes differently branded and advertised products which nevertheless have the same functional performance. The problem is that highly advertised brands will typically have higher price dispersions because they are more widely distributed, across a large number of different retail formats with a variety of different margins. Private label products, on the other hand, typically are sold in only one chain, and therefore have far less price dispersion. Store check illustration We illustrate our concern with a recent store check (which should not be interpreted as anything except illustrating the point) and two hypothetical examples. We looked at extra-strength acetaminophen caplets across different distribution channel types, selected for the different levels of convenience they offer (drug store, warehouse, convenience store, gas station and airport shop). We noted the prices of a major national brand s caplets 2 (Tylenol) and store brand caplets in each channel type, where available. Across this sample, the price dispersion of the national brand only was 1.4x (highest to lowest price) for the 24-pack and 1.3x for the 250-pack. (See Exhibit 2). There was no dispersion across channel type for the store brand because each channel type carried a differently labeled store brand. Dispersion of all the store brands together was 1.3x for the 50-pack, and 2.5x for the 500 pack. Dispersion across the national and store brands 17

19 combined was 1.7x for the 24-pack and 2.1x for the 250-pack. For interest, we also looked at price dispersion across sizes (in terms of cost per caplet). The national brand had a dispersions of 1.3x (highest to lowest price per caplet) in the convenience store channel and 2.4x in the drug store channel. The store brand dispersion was as high as 4.6x (in the warehouse channel). Comparing across brand, channel and size, it is possible to buy an Extra Strength acetaminophen for as little as 0.8c a caplet (warehouse store brand, 500-pack) or as much as 37.5c a caplet (airport shop, 2 pack), which represents a price dispersion of almost 50x! Exhibit 2 Variable Price dispersion (range) Channel 1.3x 2.5x Brand 1.6x 2.1x Size 1.3x 4.6x The central problem with price dispersion (relative price) rather than absolute price as a measure of market efficiency is that much of price dispersion could be explained by the legitimate increases in convenience offered by different distribution channels. Hypothetical illustration 1 Consider also the case in Exhibit 3. This illustrates a hypothetical but not unrealistic situation where a higher relative price coincides with a lower absolute price. Recall that relative price is the ratio or difference between the price of the most and least expensive of a functionally equivalent product, measured in this case at retail; this is the same as price dispersion. Absolute price is the average price of the same set of products. Scenario A represents a situation where the advertised brand (typically the national 18

20 brand) goes on deal frequently. In this case it is off deal in week 1, and on deal in week 2 at a significant retail price discount. In scenario B, the advertised brand does not go on deal; it is Every Day Low Priced (EDLP). The unadvertised brand (typically the private label product) is assumed to not go on deal in either scenario. In addition we make a simple, and realistic, assumption that when the advertised brand is on deal its sales increase at the expense of the unadvertised brand as well as at the expense of its own non-deal sales. The resulting situation has Scenario A with a higher relative price but a lower absolute price, and the opposite for Scenario B. Which scenario increases consumer welfare? We would argue that consumers are in aggregate clearly better off in Scenario A, where although the relative price, or price dispersion, is higher, the average amount paid is lower. Further, the opportunity for consumer to find the product at lower prices is enhanced in Scenario A. Exhibit 3 Scenario A: Advertised brand frequently on deal* Scenario B: Advertised Brand is EDLP* Week 1 Week 2 Week 1 Week 2 Retail Price Advertised Brand $5.00 $3.00 $4.00 $4.00 Unadvertised Brand $2.90 $2.90 $3.00 $3.00 Units Sold Advertised Brand Unadvertised Brand Absolute Price $3.19 $3.50 Relative Price 1.67 x 1.33 X *In both scenarios the Unadvertised Brand is EDLP 19

21 Hypothetical illustration 2 For a twist on the above example, imagine a situation where Scenario A offered a higher relative price (price dispersion) and a higher absolute price, while Scenario B offered a lower relative and absolute price. Would scenario B be the more attractive one in every case? Not necessarily. The lowest price in Scenario A is lower than the lowest price in Scenario B: a very low price is available to society in Scenario A, for those who care for it, that is not available in Scenario B. Whether the choice to buy at that lowest price is informed or uninformed cannot, we believe, be determined merely from the existence of a wide dispersion of prices. Ratchford, et al, correctly, we believe, argue that consumer choice probabilities must be taken into account when evaluating the potential losses from an inefficient market, and this weighing of price by choice probabilities is very similar to our concept of an absolute price. Increases in welfare We should also recall that a wide price dispersion on a particular product can even lead to increases in consumer welfare when it allows market segments to be served which could not afford the product if prices were closer to the mean (Schmalensee 1981). While questions of the effect of price on distributive justice are outside the scope of this paper, it would be interesting to explore to what extent greater price dispersion can actually benefit society. Such benefits might result from a transfer of wealth from segments, who are willing to pay a premium for the same item for services, such as convenience, to segments willing to go through extra effort (e.g. clipping coupons) to get the cheapest possible price on that item. It seems to us that there is implicit recognition of this in discounts that are typically offered to seniors and students, for example. Any 20

22 serious inquiry along these lines must take into account the influences of mobility and education. For example, poorer consumers often have less ability to search for the best price (e.g. do not own a car; cannot afford to buy in bulk; cannot afford the membership fee at a warehouse club); as we said, these questions are interesting but outside the scope of this chapter. Internet and role of price dispersion Recent work on Internet commerce also highlights the inadequacies of price dispersion as a measure of consumer welfare. A study of prices of books and CDs sold through a number of Internet and traditional retailers found that price dispersion of CD's sold online was approximately equal to those sold in traditional outlets, while price dispersion of books was actually higher over the Internet. This is a surprising finding, given the low search costs of the Internet. It led the authors to conjecture that something other than market inefficiency was at work (Brynjolfsson and Smith 1999). Since there is probably far less variation in the mobility, wealth, and education among those buying online compared to the rest of the population, these findings are particularly interesting. Overall, while we believe that Ratchford et al. have made a significant contribution to the question of market efficiency measurement, we find that price dispersion is an inadequate and potentially misleading measure of impact on consumer welfare. Reconciling the Market Power and Information Schools There have been three attempts to reconcile the apparent contradictions between the Advertising = Market Power and Advertising = Information schools. These attempts discuss the retailer-manufacturer dynamic; the importance of preference strength and 21

23 consideration set size; and the difference between price and non-price advertising. We will briefly review each. Retailer-manufacturer dynamic Albion and Farris (1987) argue the importance of recognizing the retailermanufacturer dynamic. They note that manufacturers do not set consumer prices by giving a certain margin to retailers. In fact the opposite is more usually the case, with retail margins being a result of the retailers own pricing decisions. They argue that retail price decisions can be significantly affected by manufacturers advertising, if such advertising increases the demand for a product and the amount of retailer competition on that product. Retailers might choose to accept a lower margin on a strongly advertised brand in order to drive traffic, build store image, or increase inventory turnover. When retailers take different profit margins on similar products, products with a similar manufacturer price can have significantly different retail prices. In some extreme cases, the manufacturer s price of one product could be higher than for another, but because of the difference in retail margins the retail price is higher for the product with the lower manufacturer price. In all cases, the effects of promotion such as coupons and rebates must be included in the price paid (Ailawadi, Farris and Shames 1999). In the above work, Farris and Albion show that, by and large, the evidence on advertising and price elasticity is consistent with the notion that advertising decreases price elasticities for manufacturers and increases price elasticity for retailers. This earlier work was later buttressed by additional research showing lower retail gross margins for highly advertised national brands (Albion and Farris 1987). Together with analyses that showed higher gross margins and higher relative prices for high-advertising 22

24 manufacturers, there is support for the argument that advertising helps manufacturers differentiate their product (advertising = market power), but induces greater retail price sensitivity, more intense retail price competition, and lower retail margins (advertising = information). The mitigating role of the existence of private label products on price is also significant. The best competition involves comparison between brands and between retailers, both inter-store and intra-store competition. Private label products are not subject to inter-store comparison, but they do provide price control through intra-store competition, offsetting the power of advertising to enable marketers to charge a higher price (see Steiner 1973). Preference strength and consideration set size A second synthesis is provided by Mitra and Lynch (1995) who argue that whether advertising increases or decreases price sensitivity will depend on two mediating variables: relative strength of preference and consideration set size. Advertising provides information about product differences among products, which can increase the consumers relative strength of preference, and therefore decrease price elasticity. Advertising also provides information about the availability of substitutes, which can increase the consumer s consideration set, and therefore increase price sensitivity. In addition, Beyond providing information on the existence of substitutes, advertising provides recall cues and, thereby, increases the number of effective substitutes considered at the time of choice. for product markets in which consumers have to rely on memory to generate alternatives, the effects of increased advertising by brands may be to increase price elasticity 23

25 If there are other stimuli increasing the consideration set (such as point of purchase material), then advertising will not have the effect on consideration set. One concern with this attempted solution is that it is difficult to separate the two different types of information (product difference and availability of substitutes). Although different ads were used in the study for reminding and differentiating, Mitra and Lynch recognized that some amount of confounding is inevitable. The same advertising message can communicate product difference to one consumer segment and availability as a substitute to another segment. Consumers who are already aware of it as a credible substitute may receive the ad as a differentiation message, while consumers who are not will receive it as an availability message. A separate limitation in understanding the impact of advertising on price sensitivity is that research typically assumes that buyers know the prices of the products they consider for purchase. When research subjects cannot recall the prices of the products being studied, the conclusion is often made that price information was not so relevant in the decision (e.g. Dickson and Sawyer 1990). However Monroe and Lee (1999) have recently argued that what consumers remember explicitly is not necessarily a good indicator of what they know implicitly, and that price information that is not remembered consciously can still exert an influence on buying decisions. Price and non-price advertising The third attempt at reconciliation is Kaul and Wittink s (1995) empirical generalization of 18 studies. This research highlighted the difference between price and non-price advertising. They found that empirical studies performed across many categories showed that an increase in price advertising leads to higher price sensitivity 24

26 among consumers. They also found studies of the effect of local advertising on price. These studies concluded that the use of price advertising leads to actual lower prices. (These studies were of categories where local advertising was prohibited in some regions and not in others, such as legal services, prescription medicines, eye glasses, eye examinations, which allowed for comparisons between regions with and without local advertising for the same products). In looking at non-price advertising they found several studies showing that an increase in non-price advertising leads to lower price sensitivity among consumers. Their main argument explaining these results is non-price advertising is used for positioning purposes thus making the brand more differentiated which, if successful, may result in lower price sensitivity for the brand (p. G156). Their thesis was not universally supported by the data, however: several studies also showed non-price advertising leading to higher price sensitivity. Kaul and Wittink focus on the distinction between price and non-price advertising. Early on in the paper, they recognize that price advertising is generally run by retailers and non-price advertising by manufacturers (p. G153). We interpret their paper as relying on the content of advertising to determine the difference between retail and manufacturer advertising; in drawing conclusions about the two kinds of advertising, they consistently assume that it is the type of advertising (price or non-price) and not the locus of it (retailer or manufacturer) that is causing the difference in price. While we have a minor dispute with the notion that price advertising always increases price sensitivity, our major concern is with the question of what causes retailers to advertise price more than manufacturers. 25

27 We do not find in the Kaul and Wittink work a recognition of the key role of manufacturer distribution policies as the key intervening variable in the market mechanisms reversing the effects of advertising on price sensitivity for manufacturers and retailers (p. G154). Instead, Kaul and Wittink raise three considerations that are relevant to the examination of the relationship between advertising and consumer price sensitivity (p. G158). These considerations refer to the composition of the consumer sample set, the measure of price sensitivity, and the type of consumers. By ignoring the impact of vertical competition on the relationship between advertising and price, Kaul and Wittink typical of the research in this area are ignoring what is probably a key factor in the question of advertising s affect on prices: whether manufacturer market power (roughly, the ability to raise prices and margins) translates into more or less reseller (retailer) market power? Importance of distribution We conclude our critical review of the literature by noting an important gap. The impact of advertising on retail prices is significantly moderated by the manufacturer s distribution policy, and yet the importance of this vertical competition does not appear to be recognized in the literature. Intensive distribution of strongly advertised brands may lead to intensive price competition among retailers, causing lower retail prices either directly, or indirectly as a result of retailer s price-focused advertising. With selective or exclusive distribution, however, such competition is mitigated, and retailers are free to take higher margins. The luxury automobile category provides an example of how exclusive distribution can override the effects of even price advertising on price sensitivity. 26

28 Although we noted above that every case of price advertising identified by Kaul and Wittinck led to increased price sensitivity, the case of Land Rover in North America provides a counter example. Land Rover used print advertisements with the price of the vehicle clearly stated, yet no one could seriously argue that this increased price sensitivity. In fact the purpose of price advertising in this case was to allow potential customers to self-select for willingness to pay the significant price premium for this car, as well as to build the luxury appeal of the car by showing everyone how much it cost. In the words of the VP at the agency in charge of the account: The price drew the right audience. It was self selecting It also saved the buyer the step of having to tell his friends how much he paid for this radically new vehicle. (Fournier 1995, p. 5). Levi s is an example of the impact of selective distribution on price: Levi s refuse to allow Wal-Mart to distribute their jeans for fear of the downward price pressure on the brand s retail price. Another example of selective distribution impacting price is the perfume industry, where premium brands maintain a price premium of 200% to 300% over mid-range brands, despite similar product quality, and product and marketing costs, primarily by limiting their distribution to department stores and staying away from mass merchandisers. Intel is another example of a strong brand that forces computer manufacturers to compete more intensely on price, because no computer has an exclusive on the Pentium processor. If one manufacturer had such an exclusive we could be sure that prices of that computer would increase (and that Intel s prices might be forced down by the manufacturer power.) 27

29 Conclusions We draw two conclusions from the forgoing discussion. The first conclusion is that research efforts on the question of the impact of advertising on price should focus on absolute, not relative, prices. Price dispersion is not per se evidence of high absolute prices. The second is that the role of vertical competition needs to be recognized explicitly. Focusing on one stage in the value chain may yield misleading conclusions on the role of advertising, branding and price levels. Absolute, not relative price. First, we believe that the preponderance of evidence and theory supports the notion that advertised products typically sell for higher prices and unadvertised products for lower, even (or especially) when differences in quality are taken into account. However, although it is often observed that strongly advertised brands tend to charge more (e.g. Kanetkar, Weinberg and Weiss 1992), an equally compelling view is that unadvertised brands charge less: in other words, advertised brands set the price ceiling for unadvertised brands. Is this ceiling a lid on prices that forces the unadvertised brands to offer consumers even lower prices than would otherwise be available? Or is the ceiling a pricing umbrella under which the advertisers earn comfortable margins and are protected from the rigors of true price competition? (Brown, Lee and Spreen 1996; Steiner ). We believe that advertised products that are widely available set the price ceiling under which other competitors are forced to price their own products and services. In the short-term, advertisers may raise or lower this ceiling with quite different effects on competition. 28