Lecture 5a: Graduate I.O. Advertising and Demand Analysis.

Transcription

1 Lecture 5a: Graduate I.O. Advertising and Demand Analysis. Ariel Pakes September 21, 2009 Notes on the Impact of Advertising. Need Table 1, 2, 3,5, and figures 1 and 2 of Ackerberg. Most empirical analysis of demand focuses on attempting to measure the quantitative impact of advertising on demand. In contrast may of the economic issues associated with advertising depend on answers to the why and how advertising affects demand. The answer to these questions effect many things among them and we will go over some of them now. However this is a literature where to the extent theory is available, it has not been connected enough with empirical work for a deeper understanding of how advertising effects different markets, and their are many issues on which theory is lacking. So this lecture will be more of an overview, than an detailed analysis of various topics. 1. The welfare implications of advertising. Note that we do engage in regulation of advertising, so there are also policy issues buried here. E.g. since 1997 we have allowed advertising for particular prescription drugs (you could mention brand names). As one 1

2 might expect direct to consumer advertising has increased substantially, to about 3.8 billion dollars a year in Was this a good or bad thing? Somehow the firms must cover the advertising by their pricing policies. So there is a question of whether there is a consumer surplus gain that counteracts the loss due to increased price. The possible gain comes from the increased number of consumers using the drugs has increased also, at least if it stops the onset of conditions that require more drastic treatment, might in the end still save money. [E.g. H-2 Antagonists and PPI s; Gerd and Ulcers.] Role of FTC. The FTC has, as part of its mission, insuring that advertising is not harmful. The leaves a number of rather basic economic questions open for analysis In what situations do advertisers have the incentives to tell the truth? Is their information that would be socially cost effective to supply to consumers that advertisers will not supply and the FTC or the FDA should? E.g; There have been fines for television advertising that did not adequately reflect FDA rules on disclosure (of either indications or possible side effects); maybe the FDA should supply the last few lines of every drug advertisement on TV (they already require certain wording on cigarette packs). There has been some empirical work on related issues; Leslie and Gin on cleanliness grades for restaurants in LA, in the QJE. It is going to be interesting to see the effect of placing calorie counts in certain food stores (e.g. Starbucks) on both; (i) what people purchase at the store, and (ii) how many people purchase 2

3 at the store. We want to clarify both whether this effects people s choices, and whether it effects the number of people going to the store (Leslie and Sorenson, 2009). 2. Understanding how to market a good. Presumably you want to target advertising to the consumers who are close to the margin of purchasing your good. So not only should demand systems tell us something about the effects of advertising, but advertising should contain a good bit of information on the nature of the demand function. Note that just off-line advertising is about 3% of GNP, and it is much more important in most consumer goods industries; and hence worth understanding. 3. The interaction among pricing and advertising. The roles of pricing and advertising in introducing new goods are related, and might give us a clue on how to think about product introductions ( introductory pricing offers ) and how to adjust the CPI for new good introductions. Even in old goods an understanding of the interaction between price and advertising can have a direct impact on issues of interest. E.g. Wei (2006)on cigarette demand. Rules placed limits on advertising to youth. Say advertising and pricing were strategic complements, so the decrease in advertising was associated with a decrease in prices. Youth are particularly price elastic. So the advertising rules seemed to generate an increase in youth smoking. After 1997 and the Masters Settlement Agreement, prices of cigarettes actually went up rather dramatically, partly because of the MSA itself, but even more so because of taxes. So if the story is consistent that should have decreased youth smoking, though I know 3

4 of no study of this. Aside. With the advent of low-cost outlets that did not have to pay taxes (Native American Reservations) the price for cigarettes differed significantly by outlet. So if one were willing to incur a time cost, and the elder population (or at least to the non-working population) were, you could smoke at lower monetary prices. So we are going to have to differentiate by outlet to get correct price coefficients by age. 4. The Advertising Market. There is a whole service industry of advertising providers (Madison Avenue, New York), and of late it is changing to make use of the internet, both as an advertising medium per se, and as a marketer of advertising for others. This involves new marketing institutions which are likely to become important and whose impacts are not well understood; e.g. position auctions, keeping tabs on what an individual buys or likes and using more directed advertising, an ability to measure pass through rates and hence to quantify the benefits from advertising to the advertiser. There is now a theory literature on position auctions (Edelman, Ostrovsky, and Schwartz, 2006) and the beginnings of empirical work (Athey and Nepikolev 2009). As well as questions about the profitability of these arrangements, there are questions about their social efficiency and how the efficiency interacts with the market structure (is it better to have one major market maker, or should there be competition, and how much integration should we allow). 5. The nature of competition in media industries. In media industries, advertising is often the primary (sometimes the sole) source of revenue. The firms are selling listeners, view- 4

5 ers, or readers to advertisers. The advertising rates per unit of media (time, page...) are a function of the number of consumers affected by the advertising. So competition is over advertising, and if you want to understand the impacts of different market structures you need to understanding the advertising market. Media industries are frequently subject to regulation for a number of reasons; (i) to insure that one agency or group does not control society s access to information, (ii) to insure that certain types of programs are produced.... The validity of these arguments depends on societies values, and given values, they depend on a changing technological environment. Seeing both the values and the technology change over time, their is a lot of debate about how to change the regulations, and it interacts with the nature of competition in the industry. This lies behind the series of FCC rulings on radio, newspaper, and TV, ownership regulations that began in the late 80 s and continues till today. The media industries are often vertical in nature with the prices set and the content provided downstream (to the consumers) determined largely by upstream interactions in buyer-seller type networks. Often the FCC cannot do much about downstream provision without understanding the impact of their actions on upstream content providers (de-bundling of cable runs into the problem that it would force revisions in the upstream market or make content providers go out of business; Yurukoglu, 2009) 6. Other Interactions between the nature of competition, advertising, and consumer welfare. 5

6 In many of the old school advertising stories advertising became a barrier to entry and hence allowed for less competitive pricing (typically the role assigned to advertising was to decrease elasticities, i.e. to make consumers less likely to substitute away from certain goods; see for e.g. the Mueller book on the reading list). However we can also make the case that advertising makes people aware of new goods by providing information on them, and hence might increase price competition,... The timing of advertising and its interrelationship with pricing contain a lot of information on the nature of demand for goods in industries where we generally think of demand being dynamic; experience goods, network goods,...it therefore should be help us unravel how those markets work, the extent of their efficiency, and the relationship of efficiency to market structure. The way advertising effects demand can effect the competitive structure of the industry. E.g. Doraszelski and Markovich (forthcoming) examine how two different types of advertising effect demand i with a numerical analysis of a Pakes-McGuire model. Types: Advertising that affects demand by putting the good in the choice set of consumers, vs advertising that affects demand by increasing the utility from purchase of consumers who all know about the product. The former generates industry structures with a small and large firm; the small firm does not want to get too large else it becomes too much of a competitor to a large firm who lowers price in response. No such behavior in the model where advertising has a direct effect on utility. 6

7 Informative vs. Persuasive Advertising. The answer to the question of just how advertising effects demand probably varies with the market being studied. Economists have generally distinguished between informative and persuasive advertising. Informative Advertising. Advertising which provides useful information to consumers. It includes Advertising which puts goods in the consideration set (marketing literature) or in the choice set. There is a literature on the dynamic implications of this (see Grossman and Shapiro, 1984; Berry and Pakes, 2001). Relatedly, advertising might jog one s memory about the existence of the good. Note that if we allow for forgetting one might need continual advertising for a good whose characteristics do not change (even if the consumer population is unchanging). Also to the extent this is true one might look at the psychology literature on memory and try to use it to gain a better understanding of advertising. Advertising which provides the consumer with more information on the goods characteristics; including its price or its location of sale. If you look at newspapers, this seems to be the dominant form of advertising in them. Much of the internet related advertising also looks like this. Closely related is advertising which enables consumer to use the 7

8 good advertised in a better, or in more, ways (increases the utility from the good). Provide recipes for using a food product. Advertising as a signal on unobservable, or at least currently unknown, characteristics of goods. Here we can get signalling equilibria in which advertising is informative about the goods characteristics even if the content of the advertising (what people actually see on TV, or read in a magazine) is not informative; see Nelson (1974) or Milgrom and Weber (1986). Stories typically based on vertical model and quality differences where it is only efficient for high quality firms to advertise. Advertising that enables more efficient matching. Advertising is often for horizontally differentiated products, and even most products with vertical characteristics have more than one such characteristic. So part of the goal of advertising is to increase the quality of matches between consumers and products, and much of what marketing is about is figuring out how to direct advertising to consumers who will find it useful. In an interesting example of this Anand and Schachar(forthcoming) have data on consumers exposures to television adds and find that; (i) exposure to an add on a forthcoming TV event can decrease as well as increase the consumer s tendency to view the promoted product, and that (ii) ad exposures decrease the probability of stopping on the wrong channels (and hence adds utility). Note that there are reasons informative advertising to continue over time even if there is no memory loss, and the good has been around for a long time. First price and other characteristics can 8

9 change over time, and the identity of consumers in the population changes through natural demographics or migration, and Though informative advertising is socially useful in the sense that it informs people of something, there maybe too much, or for that matter too little, of it. For e.g. different goods that are essentially identical are often advertised against each other, when one piece of information might be sufficient for the consumer; so the social cost of providing the advertising may exceed the social information benefit. Indeed this was the original reason for precluding TV advertising for prescription pharmaceuticals to mention a name for a drug; they could just say that there is a drug available for..., see a doctor (changed in 1997). Note that the costs of advertising should include the time cost of the consumer (spam,...). On the other hand one firm may advertise a good of a particular type, make people aware that this type of good is available, and lead those people to buy another good of the same type in which case the firm does not internalize the social gain to advertising. Persuasive Advertising. Changes tastes. Hard for a utilitarian theory to evaluate whether it is welfare enhancing or not (need a way to prefer one set of preferences over another). That does not mean it does not exist, and one might want to analyze its positivist implications; especially as it interacts with other aspects of the economy. So there is still reason to figure out how it operates: It is often associated with how other s perceive me (image or 9

10 prestige effects). If I drink the in beer the group will think I am an in person,... This is often, though not always, hard to distinguish from the signalling story. It can be associated with my self perception. I wear the running shoes that Michael Jordan wears because it makes me feel like Michael Jordan. Also hard to distinguish from signalling. It simply changes my relative preferences for the different goods. This is the old story, and it is hardest to analyze. Note. Often informative and persuasive arguments go together. Consider the breakthrough advertising campaign for Cadillac; it was trying to inform people that Cadillac had indeed changed its characteristics and to persuade a young audience that Cadillac was hip. From GM s point of view it seems to have worked. The Costs of Advertising. The early authors (especially Chamberlain, 1938) often claimed that advertising was subject to decreasing costs and that this provided a reason for concentration. Moreover when you read about the cost savings that firms predict to emanate from a merger they often claims savings in distributional and marketing costs. We know something about the cost of advertising on some media, as at least a part of the cost is quoted. On TV and radio in listenerminutes, in newspapers and magazines in reader-pages, and on the internet through amount paid for a click-through. There are usually other costs associated with advertising that less is known about like the cost of negotiating contracts. 10

11 There is also a question of the efficiency of the advertising, and the how to measure it. Their is a whole industry which attempts to do the latter for some media (Nielsen ratings for TV, and a similar rating system for radio), and the fact that we can at least measure click throughs has had a big effect on internet advertisers, and this is becoming a large part of advertising. There are a couple of points to keep in mind here. In considering mergers the savings in promotional costs may simply be that when the competitors are gone their is less advertising (the business stealing effect is muted); again their is a question of whether this is good or bad. There may be fixed costs of advertising contracts (like negotiations), which may be smaller per customer reached for national brands, or for multi-product firms. Similarly national media (like Clear Channel) might generate less transacting costs to reach a given sized audience than local media. This is one of the arguments for allowing more concentrated ownership structures in the media. Issues in the Simple Micro Theory on Advertising. As one might expect the theoretical literature on advertising is generally limited to fairly stylized models, and even in those models the signs of alternative effects are often not determinate. Here are some examples of the complications that arise. 1. Market incentives for advertising that informs individuals about the existence and characteristics of the good can either be 11

12 insufficient or excessive from a social point of view depending on the details of the specification. To see this assume that the private cost of advertising depends on the number of people the ad reaches and that private cost equals social cost (the first assumption is generally true, and is the reason for rating systems on TV and Radio; the second is more questionable but hard to replace with anything better). Think of advertising a product for which there is substitutes. The advertiser s gain from this advertising is the price minus the marginal cost of the advertised good when the consumer substitutes it to the other good, while the consumers gain is the difference between the marginal utility minus price of the two goods; and there is no necessary relationship between the two quantities. One can derive similar dichotomies in signalling games (is signalling socially beneficial or not). The argument for advertising seems to be stronger for the first good of a type introduced to consumers, as consumers will buy as long as marginal utility is greater than price; and for all but the marginal purchaser marginal utility will be greater than price generating a social surplus not captured by the advertiser. 2. When and where will advertising be mis-informative. That is, would it be an equilibrium outcome for a good to advertise a characteristic that it doesn t have or better yet what types of goods are likely to exaggerate claims in advertising? There is a public policy issue here as one of the mission s of the FTC is to monitor the truthfulness of advertising claims. So one would think that there would be some theory telling us when claims are less likely to be truthful. For e.g. does the incentive for a product to exaggerate 12

13 what it can do depend on the ease of verifiabilty of the statements made? Relatedly does it depend on the extent of the harm if the claim is shown incorrect, and how does that relate to punishments? 3. Externalities. There can be externalities to advertising when a firm which advertises its products makes consumers aware of a range of products and the benefits of the consumer being aware of this range of products are not captured by the advertiser (e.g. patented drug innovation and the entrance of generics; typically advertising falls to zero after generic entry); so this must be weighed against any other incentives for excessive advertising. 4. Price Effects. One can write down models of informative advertising where advertising expands the choice set of individuals, making demand more elastic, and making prices fall. Or one can write down models where what advertising does is modify the utility function and make consumers less elastic with respect to prices and cause higher prices. E.g. Benham, 1972 finds prices of eyeglasses fall after the firms were allowed to advertise, Waldfogel and Mylos, 1999, on liquor advertisements in Rhode Island; find no change in prices after advertising was allowed. 5. Timing. The timing of informative advertising can be related in important ways to other unobservable and/or network characteristics, that horizontally differentiate among consumers; thus when marketing a new good you might want to get to consumers before competing goods are introduced to make sure that people learn how to use your variant of the good (software), or learn that your 13

14 variant is adequate for them when other variants may (even if they are unlikely to be) harmful (different drugs for the same condition). Empirical Work on Advertising. The old empirical literature on advertising has largely done one of the following things; questioned how much advertising effects demand, rather than how advertising effects demand (just stick advertising, either a flow or a stock, into the demand function). There have also been some studies examining patterns in advertising or in advertising intensities across different industries. The intention here is typically to show the relationship between advertising intensity and concentration or characteristics of the product usual claim is that it is larger in more concentrated industries and in retail industries where one might think informative advertising important, There are some newer studies, which focus on either the content of advertising (trying to distinguish between prestige vs. informative advertising etc.) the way advertising effects choices (see Ackerberg s work below) In media industries, what we can learn from the advertising about the objective function of the advertiser (Gentzkow and Shapiro 2006). We come back to studies like this later. I have referred to a number of these studies above. Instead of reviewing this literature in more detail, I am going to go over some 14

15 empirical results a study which attempts to get at the role of advertising by looking at some reduced form results on micro data. This will also give me a chance to discuss some of the data, empirical and econometric issues with reduced form work of this kind. Ackerberg (RAND, summer 2001); tries to distinguish advertising which has a direct impact on the utility function (he calls it prestige or image effects) from informative advertising. To make headway at getting at informative advertising he chooses a new product (Yoplait 150), whose characteristics were unknown when the sample started and did not change much over the sample (some changes in price). His basic argument is that prestige or image effects might impact both experienced and inexperienced consumers, whereas informative advertising in this market should really just impact inexperienced consumers. Data is scanner data that is becoming increasingly available. The data follows the shopping trips of 2000 households among 80% of the supermarkets and drugstores over three years ( ). He has weekly data on prices, and AC Neilsen data on household TV advertising exposures for about 1/2 the households over the last year of the sample. Note that Yoplait is a good which is hard to store (at least relative to the other products that were available). So one might worry less about sales and the stockpiling of goods (and were we to worry about this we would need a dynamic model of demand; see Hendel and Nevo, Econometrica, 2006). Also Yoplait was newly introduced. So initial uses are in sample, and one could distinguish between the effects of advertising on experienced and inexperienced consumers. 15

16 Tables 1 and 2; Figures 1 and 2. the advertising share of Yoplait is much larger than the marketing share i.e. the new good advertises disproportionately, which is indicative of informative effects. Of the 350 families that buy Yoplait, most buy it only once, but there is another mode at more than 15; people learn their tastes. price and quantity are negatively correlated (stockpiling might make you worry a bit about the interpretation of a price elasticity here can you think of how one might test for it? Stockpiling is a frequent problem with analyzing the pricing impact of sales at grocery vendors.) both price and quantity are higher when advertising is higher; assuming that the causation runs from advertising (and not from exogenous movements in say the level of demand which effects both), it seems that advertising has some positive impact on (gross) revenue there is lots of variance in advertising over time (much more than in price, which is also a control, for example). This is true in most markets where I have seen the data (prescription drugs, entertainment industries, retail markets). Look to Figures. The fact that advertising has a lot of variance over time probably means it should allow us to get sharp answers to questions involving the impacts of advertising (sharper than the analysis of the impact of price, though the marginal conditions for the two are similar if there are no dynamic effects). 16

17 On the other hand there is a question of why advertising varies. That is advertising is a control to the firm, so if there is something that impacts demand we expect it to also impact advertising. So there is a simultaneity problem and to get a handle on it we need to know something about the sources of variance in advertising. One great help in the analysis of the impacts of price is that we have pricing equations; in order to follow the analogous strategy for advertising we need a model for how advertising effects demand (at least up to a set of parameter values we might estimate). A problem is that we generally expect the impacts of advertising to be felt over time, and so we need a dynamic model for the analysis. We come back to this later in the course. Table 3 and 5; Differences between Repeat vs. Initial Purchases. Table 3 Ads has a significant impact on all but one of the specifications for initial purchases, and that specification is the specification which has prior adds over a 2-week (instead of a four day) effect, and forgetting might have a role here Ads does not have a significant impact on any of the specifications for Repeat purchases, though what effect there is, is positive. Table 5 specification U i,t = α i +X i,t β 0 +f(q i,prior, β 1 )+f(q i,prior, Ads, β 2 )+ɛ i,t, 17

18 where we treat the α i as a random difference in taste which is independent of everything in X i,t but obviously not of past purchase experience, and is sometimes allowed to be correlated with initial taste characteristics. problem with having an α i together with distinguishing the importance of past choices and their interaction with advertising, leads to forming the likelihood of a sequence of trips (from the first), drawing individual α i and holding it fixed throughout, and going to a simulation estimator. Explain: simulated likelihood or method of moments, explain relationship to the problem of heterogeneity vs. state dependence. In this context look to the first two columns and note that the biggest difference in going from the models without random effects to models with random effects is on; the interaction of advertising and experience (which gets cut in half) and on the number of previous purchases (which goes from positive to negative; this might explain why it was taken off the market). Now those who tried once and like it, like it partly because they have a large α and hence there subsequent purchases are driven by that fact rather than by any additional advertisement or by something else they experienced while consuming it. The second two columns make this more continuous and analyze the effect of advertising as a smooth function of the number of previous choices, and here we get a significant negative coefficient. He also tries a three choice logit where the additional choice 18

19 is to try another type of yogurt with no difference in the effect. Looks like the effect of experience is at least important here. The average effect of an increase of a doubling of advertising on an experience consumer was about equal to the effect of a 10-20% price fall. He tries a structural analysis to get a more detailed view of the effects in a separate paper (IER, August 2003). Uses a model where a person actually learns their taste for Yoplait by consuming it and might use advertising to infer quality). There are a lot of different effects here which one might analyze, and in principle a rich enough data set should be able to distinguish them. I leave you to decide whether his data was rich enough. If not there still is some value in the logical exercise of showing exactly what are the impacts of the different effects of advertising in a suitably dynamic model that allows for various forms of learning. 19