L12 - Product differentiation and advertising

Question 1

What is vertical and horizontal product differentiation?

Answer 1

Vertical - Means one product or service differs in overall quality from another

Horizontal – products or services are of the same or similar overall quality but offer different combinations of characteristics

Question 2

What is natural vs. strategic product differentiation?

Answer 2

Natural – the distinguishing characteristics arise from natural attributes or characteristics rather than deliberately created

Strategic – deliberately created

Sometimes, strategic enhancement of natural characteristics

Question 3

What are five sources of natural product differentiation?

Answer 3

Geographic variation – location of seller

New technology

Brands and trademarks

Community of national differences

Consumer tastes and preferences

Question 4

What are four sources of strategic product differentiation?

Answer 4

Additional services

Rate of change of product differentiation - Consumers might be urged to purchase new styles or models with superficial changes in characteristics

Factor variations – e.g. claim more skilled employees or superior raw materials

Consumer ignorance – allow firms to exaggerate the extent of differentiation

Question 5

How can we set up a model to find the socially optimal level of product differentiation?

Answer 5

Monopolistic competition of firms

Consumers have preferences and firms compete to attract consumers by differentiating their products

Each firm’s demand is a continuous function of its own price and prices of its rivals

Under monopolistic competition, welfare depends on how consumer and producer surpluses change due to an increasing number of firms

Question 6

What happens to the producer surplus when more brands enter the market (product differentiation)?

Answer 6

As N increases, i.e., there will be more and more companies enter the industry with their differentiated product (hence number of products increases), they take a piece of the market. First, the total profit increase N π (N) although profits for existing businesses fall because some consumers substitute away from existing product to
new variety (assumption: no switching costs)

But in the end, there come so many companies in that total profits starts to decline - and abnormal profits go to zero so that all firms make a normal profit

Consequently, producer surplus goes down to 0

Question 7

What happens to the consumer surplus when the number of brands increase (product differentiation)?

Answer 7

As the number of brands increases consumer surplus increases - consumers can now buy more products and there will always be consumers who will give more for these products than the final market price, therefore CS > 0

The effect is present in part because the price falls on the existing products provider, and partly because there are new products into the market – the overall market for all product variants grows

Therefore, the curve CS (N) is increasing from left to right

Question 8

What happens to the total surplus as the number of brands in a market increase?

Answer 8

PS is declining from a certain point and CS is constantly increasing as the number of brands increases N1 to N2

At some point, the negative impact from lower PS cause the sum of PS and CS to go down, the social efficient point in the figure is N * - the optimum number of brands (where total surplus is maximum)

Question 9

What is informative and persuasive advertising?

Answer 9

Informative – provides consumers with factual info about existence of product or about attributes

Aims to give consumers information with which to make informed choices that will help them maximise their (exogenously determined) utility functions

Persuasive – makes claims which may not be objectively verifiable, aiming to change consumers’ perceptions of product to stimulate sales

Seeks to shift consumers’ tastes and thereby change the shape of their utility functions (no longer exogenous) in a direction favouring the advertising firm.

Question 10

Name 5 reasons why firms invest in advertising campaigns (motives)

Answer 10

To launch a product or service

To provide info on price and quality (informative)

o Important if the market is characterised by frequent changes in technology

o Important if Lemon problem: if on the market both high- and low-quality products (e.g. used cars) simultaneously sold and consumer do not know a used car’s real quality

To increase or protect market share (persuasive)

To establish a brand’s image or strengthen consumers’ brand loyalties – goodwill and positive reputation can act as significant entry barriers

Question 11

How can we assess the importance of advertising as a form of non-price competition?

Answer 11

Industry advertising expenditure as a proportion
of industry sales, known as advertising intensity or the industry’s advertising-to sales ratio provides an indication of the importance of advertising as a form of non-price competition.

Question 12

What is the optimal level of advertising in monopoly?

Answer 12

Assume AR (same as market demand) function depends on level of advertising expenditure

Assume diminishing returns to advertising

Production costs assumed to be linear in output

Assumed the difference between each successive
level of advertising expenditure is the same, and
equal to ∆a

Advertise until increase in operating profit is equal to additional expenditure

Question 13

What is the Dorfman-Steiner condition?

Answer 13

Implies that for profit maxmization the ratio of advertising expenditure to toal revenue should be proportion to the ratio of advertising elasticity of demand to price elasticity of demand

When the advertising elasticity is high relative to the price elasticity, it is efficient for the monopolist to advertise (rather than cut price) in order to
achieve any given increase in quantity demanded.

When the price elasticity is high relative to the advertising elasticity, it is efficient to cut price (rather than advertise) in order to achieve any given increase in quantity demanded

If the company has a high markup, can get a larger reward to increase sales - for example using advertising. Therefore, an advertising strategy attractive.

Question 14

What is the profit-maximizing advertising in perfect competition?

Answer 14

Dorfman-Steiner condition provides justification for the fact that there is no role for advertising in perfect competition

The demand function of the perfectly competitive firm is horizontal, and the firm’s price elasticity of demand is infinite. Accordingly, the ratio of the firm’s advertising elasticity of demand to its price elasticity of demand is zero. The profit-maximizing advertising-to-sales ratio is also zero. If the firm can sell as much output as it likes at the current market price, there is no point in advertising.

Question 15

What is the relationship between advertising, market structure and concentration?

Answer 15

The profit-maximizing advertising to-sales ratio should be zero under perfect competition, positive under oligopoly and monopoly, however, larger under oligopoly.

Question 16

How may advertising be a barrier to entry?

Answer 16

Need to advertise increases start-up costs

High levels of advertising build up reputation effects

Economies of scale in advertising – (1) firms must advertise a large number of times before advertising messages permeate the minds of consumers and produce increased sales. (2) large-scale advertisers may pay less per unit of advertising than small-scale advertisers. (3) an
indirect ‘distribution effect’ arises when retailers increase stocks of products in response to a manufacturer’s advertising campaign, in the expectation that demand will increase

Question 17

How does advertising differ for the incumbent and the entrant?

Answer 17

Assume entrant has to advertise for the first time, a threshold level of advertising expenditure must be achieved before its advertising begins to have any positive effect on sales

The incumbent is assumed to have advertised its product or brand in the past.

Past advertising is assumed to have been effective in building up name recognition and consumer brand loyalty: any advertising expenditure in the current period produces some increase in sales. Like the entrant, however, the incumbent is subject to diminishing returns to advertising, and may reach a saturation point beyond which further advertising has a harmful effect on sales.

Question 18

What does the advertising response functions imply?

Answer 18

Thanks to its past advertising investment, the incumbent achieves more sales for any given amount of current advertising expenditure. This implies the incumbent has an absolute cost advantage over the entrant.

Furthermore, because the gradient of the advertising response function is increasing over the lower end of the range of values for a, and because the threshold level of advertising expenditure is effectively a fixed cost from the entrant’s perspective, there are economies of scale in advertising

If advertising costs are incorporated into the firms’ total cost functions, economies of scale in advertising may change the location of the minimum efficient scale of production. This in turn
may alter the extent to which the cost structure, and in particular the need to be producing on a scale sufficiently large to be cost-efficient, acts as a barrier to entry.

Question 19

What is the profit-maximizing advertising for an oligopoly?

Answer 19

We need to take interdependence into account

Two cases:

Case 1: Firm B is passive to A’s advertising strategy. First, there is an increase in total industry demand, ¬Q, part of which goes to firm A. Second, there is an increase in firm A’s share of total industry demand

Case 2: Firm B reacts to A’s advertising strategy.

The change in industry sales due to firm B’s advertising is positive, so is the change in A’s market share

However, the change in firm A’s market share due to the advertising of firm B is negative

Suppose the effect of advertising on each firm’s market share generally tends to dominate the effect on total industry demand.

In the most extreme case, it could be assumed that the change in industry sales due to B and A’s advertising respectively are equal to each other, hence 0

Suppose also each firm tends to ignore or underestimate its rival’s reaction to its own advertising decisions.

In the most extreme case, suppose firm A assumes that the change in advertising expenditure implemented by B divided by the change in advertising expenditure implemented by themselves is equal to 0, but it is actually higher than zero

Then, firm A will set advertising-to-sales ratio at a level too high for profit maximization

If firm B has a similar tendency to underestimate the size of firm A’s reactions, there will be a general tendency for the firms collectively to advertise more heavily than they would if they took proper account of their interdependence.

Question 20

Why is advertising elasticity of demand higher for oligopolists than for monopolists?

Answer 20

When firm A increases its advertising expenditure, it
benefits not only from an increase in total industry demand (as does the monopolist) but also from an increase in its own market share. This ‘market share’ effect does not apply in the case of the monopolist.

Question 21

What is the effect of informative advertising, consumers gain?

Answer 21

MC: constant cost to the consumer by searching product information for another hour

MB1: The prize for the consumer by searching product information for another hour without advertising

The provision of information through advertising reduces the marginal benefit gained from each additional hour of information search, shifting the marginal benefit function to the left

The consumer will seek information until MB1=MC => s1 search time

MB2: The prize for the consumer by searching product information for another hour with advertising -> The consumer will seek information until MB2=MC => s2.

Notice at s2 < s1, i.e. advertisement reduce consumer search costs.