Informative Advertising as Signal of QualityE0%CD%A1... · Actually, advertising may informative to some consumers and uninformative to others as they have diﬀerent levels of knowledge

Introduction

The Model

Dynamic of Advertising over the Product’s Life Cycle

Informative Advertising as Signal of Quality

Pornthep Benyaapikul

Faculty of Economics, Thammasat University

Department Seminar: 29 August 2011

Pornthep Benyaapikul Department Seminar, 29 August 2011

Introduction

The Model


Outline

1 IntroductionRoles of AdvertisingEmpirical EvidencesAdvertising Behaviours over the Product Life-Cycle

2 The ModelModel DescriptionSeparating EquilibriumPooling Equilibrium.

3 Dynamic of Advertising over the Product’s Life CycleSeparating EquilibriumMarketing Strategy


Introduction

The Model


Roles of Advertising

Empirical Evidences

Advertising Behaviours over the Product Life-Cycle

Advertising as Quality Signalling DeviceNelson (1970): Advertising contains no solid information.

Information contents are nonverifiable especially for experiencegoods.Can only be rationalised as an instrument that informsconsumers indirectly about quality. (Advertising signalsquality)Consumers infer quality from the volume of exposures ratherthan its content. (Milgrom and Roberts 1986 and Kihlstromand Riordan 1984)


Introduction

The Model



Empirical Evidences


Informative ViewAdvertising delivers direct and explicit information.

Some information is delivered directly. (Stigler 1961; Butter 1977;and Grossman and Shapiro 1984)

ExistenceLocation

AttributePrice


Introduction

The Model



Empirical Evidences


Empirical Evidence IAdvertising provides information...

Studies from Marketing literature confirm that advertisingdoes contain some information about quality. (Resnik andStern, 1977; Abernethy and Franke, 1996)

Advertising both signals quality and conveys direct information(Ackerberg 2003 on yougurt industry; Shum 2004 onbreakfast-cereals; Erdem et al 2008 on ketchup industry)

Actually, advertising may informative to some consumers anduninformative to others as they have different levels ofknowledge about the advertised product, e.g. technicalspecification of computers, mobile phones or cars.


Introduction

The Model



Empirical Evidences


Empirical Evidence IIbut not every information is prefered by all.

Product attributes such as thickness of ketchup, spiciness offood, design of cars are not all liked by all consumers.

Increased exposure to ads may reduce demand if the matchbetween preference and attribute is lower than average match(Anand and Shachar, 2004)


Introduction

The Model



Empirical Evidences


Empirical EvidencesRoles of Advertising

To conclude:1

Advertising both signals quality and conveys real information.

2

Some information contained in advertising enable consumers to

learn a “match” between attributes and preference which

create demand dispersion.

1st contribution of this paper: Incorporating these empiricalfacts into a unified model that explains how informativeadvertising can signal quality.


Introduction

The Model



Empirical Evidences


Dynamic of Firm’s Advertising Behaviours over the ProductLife-CycleEmpirical predictions of standard advertising signalling models.

Milgrom and Roberts (1986):Two periods model with repeat purchase

High quality product is more costly to produce

High price alone is not the most cost effective way to signalquality

Multiple signals (Price&Advertising) are used in the 1st periodReducing price towards monopoly level

Positive (dissipative) advertising

Empirical Prediction: Lower (supra-monopoly) price andpositive advertising in the firrst period to increase consumerbase. Then, higher price with no advertising thereafter.


Introduction

The Model



Empirical Evidences


Empirical FindingsStandard signalling models cannot explain advertising dynamics.

Advertising for a newly introduced brand is primarily to provideinformation on inherent product characteristics to uninformedconsumers. (Ackerberg 2001,2003)

Dissipative advertising is relevant when the product is wellestablished; it increases and peaks after the introductoryperiod and then slowly declines with consumerexperience.(Horstmann and MacDonald 2003)

High prices are used initially and decline over time (Curry andRiesz, 1988 and Horstmann and MacDonald, 2003)

2nd contribution of this paper: Proposing a static advertisingsingnalling model that qualitatively captures these stylisedfacts by allowing for both informative and dissipativeadvertising.


Introduction

The Model


Model Description

Separating Equilibrium

Pooling Equilibrium.

The Basic ModelDescription

A new product with uncertain quality q 2 {H,L} privatelyknown by the firm is introduced. The prior belief that a firmproduces high-quality product is l 2 (0,1).The cost of producing one unit of the product is cH = c > 0and cL = 0.A continuum of potential consumers with mass 1 and identicalreservation price for a low quality product, q 2 (0,1).Each consumer is characterised by her idiosyncratic willingnessto pay for the high quality product, qi 2 [q ,1+q ]. Itdetermines a match between the product characteristics andpreference.


Introduction

The Model


Model Description



The Basic Model

There are some already informed consumer. Let X denote theratio of informed to uninformed consumers. Informedconsumers know both product quality and their valuations fora high-quality product. (There are initially X

1+X informedconsumers)Uninform consumers are ex ante identical; they do not know qand qi unless they are reached by advertising with reasonableprecision. The ex ante distribution of qi is qi ⇠ U [q ,1+q ].The seller can inform its true quality through informativeadvertising. The cost of advertising campaign that informs afraction a of consumers the true quality is C (a) = 1/2a2

where 0 a 1. Advertising expenditure is observable to allconsumers.


Introduction

The Model


Model Description



The Basic Model

We assume for simplicity that when a consumer learns qualityof the product (q), she also learns the match (qi ) .Perfect Bayesian Equilibrium (PBE) is employed as anequilibrium concept.Equilibrium seclection refinements used are Intuitive Criterion(Cho and Kreps, 1987) and Undefeated Equilibrium (Mailathet al, 1993).


Introduction

The Model


Model Description




Consumers observing price and advertising expenditureimmediately know the product quality (not necessary knowtheir valuation for the product).A low-quality firm will never advertise in any separatingequilibrium; so, (pL,aL) = (q ,0)

DefinitionA monopoly is a niche market supplier if it serves only informedconsumers knowing their valuations. Otherwise, a monopoly is amass market supplier.


Introduction

The Model


Model Description



Niche Market Advertising Separating Equilibrium

The monopolist serves only fully informed consumers. That ispN > 1/2+q .Equilibrium with profit maximisation implies�pN ,aN�= argmax(p,a) (p� c)

h⇣X+a1+X

⌘(1+q �p)

i�C (a)

Belief system: l e �pN ,aN�= 1 and 0, otherwise.Signalling is not an issue in a niche market equilibrium as atprice pN only consumers knowing their valuations (and hence,product quality through advertising) would want to buy.


Introduction

The Model


Model Description



Mass Market Advertising Separating Equilibrium

The monopolist serves both fully informed consumers(willingness to pay = qi ) and consumers who do not learn theirvaluations and product’s quality from informative contents ofadvertising (willingness to pay =1/2+q).Price and advertising expenditure are used as signals of highquality by the latter group of consumers.The low-quality firm will not mimic a high-quality supplier’sprice and advertising (p,a) if

p (L,l e = 1,p,a) p (L,0,q ,0)

or,

p �q + 1/2a2

�

1�a(1+X )

| {z }P (a)


Introduction

The Model


Model Description



Non-Imitating ConditionA lower bound of price-ads set that a L-firm has an incentive to imitate

�

1/2 + �

�

L-mimic

P��)

H-firm chooses aM 2 [0,a] and the corresponding price alongP (a)that maximise its profit.


Introduction

The Model


Model Description



Existence of Mass Market Equilibrium

This implies:

aM = argmaxa (P (a)� c)X +a1+X

(1+q �P (a))+1�a1+X

��C (a)

and pM = P�aM�.

Let

f (c,q ,X )⌘ p⇣H,l e = 1,pM ,aM

⌘�sup

�p (H,0,ep, ea)

��(ep, ea) 2 R2

+

be the difference between profis from mass market equilibrium andthe best deviation strategy.


Introduction

The Model


Model Description



Existence of Mass Market Equilibrium

PropositionA mass market advertising separating equilibrium in which thehigh-quality firm maximises its profit exists if either c < q or c � qand f (c,q ,X )� 0.

Mass marketadvertisingequilibrium

Niche marketadvertisingequilibrium


Introduction

The Model


Model Description



Discussion

For the firm operating in the mass market, informativeadvertising is demand reducing.While some consumers informed by advertising refuse to buyhigh-quality product at equilibrium price, every informedconsumer will not buy from low-quality supplier.Asymmetry in return of advertising between two types of firmmakes advertising an effective signal.


Introduction

The Model


Model Description



Pooling Equilibrium

Both high- and low-quality suppliers set the same price andadvertising intensity (p⇤,a⇤).Uninformed consumers’ max willingness to pay is l

2

+q(expected utility from consumption given belief about firm’stype).Both types of firms must be willing to pool.


Introduction

The Model


Model Description



Pooling Equilibrium

�

P��)

�

1/2 + �

�/2 + �L-mimic

L-pool

� ’


Introduction

The Model


Model Description



Existence of Pooling Equilibrium

Proposition(p⇤,a⇤) and a belief system l e (p⇤,a⇤) = 1 and l e (p0,a 0) = 0 forall (p0,a 0) 6= (p⇤,a⇤)constitute a pooling equilibrium if

1 max {c,P (a⇤)} p⇤ l2

+q2 p (H,l ,p⇤,a⇤)� p (H,0,ep, ea) for all (ep, ea) 2 R+⇥ [0,1).

There are multiple pooling equilibria. We apply the refinementconcept of Undefeated Equilibrium (Mailath et al 1993) toselect away equilibrium prices that give unreasonable surplus toconsumers.


Introduction

The Model


Model Description



Pooling Equilibrium

Niche marketadvertisingseparatingequilibrium

Mass marketadvertisingseparatingequilibrium

Pooling equilibrium at(p*��*)= (�/2 + �,0)


Introduction

The Model



Marketing Strategy

Advertising DynamicAdding uninformative advertising expenditure

To make prediction on a firm’s advertising behaviours over theproduct life-cycle, we need to extend th model to representmarket environment in each stage of product’s life.Suppose firms can spend on both informative anduninformative advert campaign but only total expenditure isobservable.Let Zq demote uninformative advertising expenditure of type qfirm. Consumers can observe only Aq = C (aq)+Zq but notits composition.Stages of product life cycle are characterised by the size ofexogenously informed consumers. Overtime, as informationabout the product diffuses, the size of these ’already informed’consumers increases. (Xgrows over product life cycle).


Introduction

The Model



Marketing Strategy

Separating EquilibriumNiche Market

In niche market, the firm supplies to informed consumers only.This mean ZN

H = 0 and conditions for existence are identical tothe one discussed before.�pN ,aN

H�=

✓1+q+c

2

, 1

1+X

⇣1+q+c

2

⌘2

◆

p⇤ �H,1,pN ,aNH ,ZN

H = 0�= p⇤ �H,0,pN ,aN

H ,ZNH = 0

�

Only informative advertising is used.


Introduction

The Model



Marketing Strategy

Mass MarketInformative Advertising no longer signal high quality

When uninformative advertising is available and consumers canobserve only total expenditures on advertising, any expenditureon informative advertising which is demand reducing in a massmarket will be matched by low-quality firm spending ondissipative advertising without losing any demand.Sending higher signals (high price and informative advertising)is no longer relatively more profitable for the high-quality.In any mass market equilibrium, a = 0.Only uninformative advertising is used.


Introduction

The Model



Marketing Strategy

Mass MarketDissipative Advertising can be used to signal quality when product is not too mature

Let�pM ,ZH

�denote equilibrium price and uninformative

advertising expenditure of high-quality firm, a low-quality firmwill not imitate if p (L,0,q ,0,0)� p

�L,1,pM ,0,ZH

�or

q � pM

1+X �ZH .

X = pM

q �1 is the propotion of informed consumer such thatwhen X > X , only price is enough for separation and theH-firm stops advertising in the mass market (ZH = 0) .Our attention will be focused on the case X X . (Theproduct is not too mature to be advertised)


Introduction

The Model



Marketing Strategy

Mass Market

H-firm problem:

maxp,Z (p� c)✓

X1+X

◆(1+q �p)+

11+X

��Z st.Z � p

1+X�q

The corresponding solutions are

pM =1+q+c

2

if c < q1

2

+q c � q

ZMH =

pM

1+X�q


Introduction

The Model



Marketing Strategy

Marketing StrategyWhen to operate in Niche vs. Mass market

H-firm compares profits between Niche and Mass marketstrategies and decides which market to operate. Define

�(X ,c,q)⌘ p⇤⇣H,1,pN ,aN

H ,0⌘�p⇤

⇣H,1,pM ,0,ZM

H

⌘

When c < q , �(X ,c,q)< 0 for all (X ,c,q). The firm has noincentive to supply information. Mass market strategy(dissipative advertising) is used over the life cycle of theproduct.


Introduction

The Model



Marketing Strategy

Marketing StrategyNiche market is more profitable for the new product

When c � q ,

�(X ,c,q) = 1

2

⇣1

1+X

⌘2

⇣1+q�c

2

⌘4

� 4qX�4(c�q)�(c�q)2X4(1+X )

When

�(X = 0,c,q) = 1

2

⇣1+q�c

2

⌘4

� (c �q)> 0

A new high-quality product will be introduced to a nichemarket when high price and informative advertising are used.


Introduction

The Model



Marketing Strategy

Product LifeMass market becomes more profitable as product is more mature

�X = ∂∂X �=�

⇣1

1+X

⌘3

⇣1+q�c

2

⌘4

� 4c�(c�q)2

4(1+X )2

�X < 0Mass market becomes more profitable when the market isbetter informedIntuitively, imitation is less profitable for L-firm; smalladvertising budget is needed to separate. Mass market profitincreases.


Introduction

The Model



Marketing Strategy

Strategy Switching

Since �(X = 0,c,q)> 0 and decreasing in X (�X < 0), if at

X = X̄ , ��X = X ,c,q

�< 0 then there exists a unique

X 2�0,X

�that the firm switches from niche market to mass

market strategy.

The switching point from informative advertising touninformative advertising, X , marks the end of introductionperiod of the new market. The market is sufficiently informedand the firm operate in the mass market: Stopping informationprovision and using uninformative ads to signal high quality.


Introduction

The Model



Marketing Strategy

Advertising Strategies in a Separating Equilibrium

��X = X ,c,q

�= 1

2

⇣2q

1+2q

⌘2

⇣1+q�c

2

⌘4

� 4q(1�2(c�q))�(c�q)28q(1+2q)

DissipativeAdvertis ingonly

Informative Adsinitially and thenswitch toDissipative Ads

InformativeAdvertisingonly


0.1

0.2

0.3

0.4

0.5

0.6Advertising

InformativeAds

Dissipative Ads No Advertising

X X

0.8

0.9

1.0

1.1

1.2

1.3Price

Intro-ductoryPhase

Mature Phase No Advertising

X X

=

pN=(1+�+c)/2pM=1/2 + �

1.41.21.00.80.60.40.20.0 X

1.41.21.00.80.60.40.20.0 X

Introduction

The Model



Marketing Strategy

Length of Introductory Phase

Introductory Phase is determined by X which, in turn, dependson c and q .Since, by definition, �(X ,c,q) = 0, applying the ImplicitFunction Theorem, we summarise comparative static analyseson the length of product introduction period


Introduction

The Model



Marketing Strategy

Length of Introductory Phase

PropositionA high-quality monopolist switches from a niche market to a massmarket advertising strategy relatively later if c is larger or q issmaller.

When c is large, mass market is less attractive. The firm iswilling to wait longer util the market is sufficiently informedand the cost of uninformative ads required for separationreducesWhen q is small, the whole market has lower valuation onaverage. Operating in a mass market becomes a less lucrativestrategy.


Introduction

The Model



Marketing Strategy

Thank You

Thank You!!!


Documents

Informative Advertising as Signal of QualityE0%CD%A1... · Actually, advertising may informative to some consumers and uninformative to others as they have diﬀerent levels of knowledge