advertising and competition
TRANSCRIPT
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 22906-6550
Tel. 804-970-2719
1
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
2
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, non-
advertising, 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 non-
advertised, 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.
3
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
4
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
5
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.
6
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
7
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).
8
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}
9
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
10
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.
11
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.
12
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
13
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
14
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
15
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).
16
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
17
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 caplets2 (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
18
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
19
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 5 25 10 10 Unadvertised Brand 10 5 10 10 Absolute Price $3.19 $3.50 Relative Price 1.67 x 1.33 X *In both scenarios the Unadvertised Brand is EDLP
20
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
21
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 on-
line 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
22
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 retailer-
manufacturer 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
23
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
24
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
25
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.
26
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.
27
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.)
28
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.”
29
At the ceiling, in the highest pricing location, sit highly advertised, high-quality,
innovative products. Significantly below, in the lowest pricing positions, sit the private
labels and “me-too” brands. Between the two is a gap, or band. Price dispersion
measures the width of this band. Such dispersion of prices, we believe, is a given. We
reject the notion that price dispersion is, per se, evidence of uninformed, inefficient
markets. Relative prices of brands in a particular set of functionally equivalent products
may not tell us much about what the absolute (average) price level of the entire set would
be without advertising. A variety of prices that offers consumers the opportunity to buy
at many different places and times is something few of us would gladly sacrifice.
Variation in price, even among similar products, is not prima facie evidence of reduced
consumer welfare. It may even be a healthy indicator of dynamism and innovation in the
category, signifying a breadth of retail availability and active price competition.
The more important question to us is the absolute height of this band itself—the
absolute price level. This is significantly more difficult to measure in a meaningful way.
Measures of profits that capture risk and the cost of investments might provide better
insight into the height of the band, if they reflect the entire supply chain. It is dangerous
to focus on a single link in the supply chain, because profits are often inversely related
among stages in the supply chain. A focus of further investigation, we believe, should be
on finding reliable methods for measuring and testing the effect of advertising on
absolute prices, given the expected variation in prices for different brands with equivalent
functional quality and even different prices for same brands at different retailers.
30
Role of vertical competition
The second conclusion that we draw in this chapter is that the role of middlemen
(especially retailers) serves as a pivot point to reverse many conclusions about price
sensitivity and monopoly power. We argue that the advertising-and-price research—with
a notable exception of the substantial contributions of Robert Steiner (1973; 1993)—
generally pays insufficient attention to vertical competition and the dynamics of the
relationship between the manufacturer and retailer. We believe the field must move
beyond the notion of merely recognizing that retailers and manufacturers are “different.”
It is true that retailers more often advertise price than manufacturers and that, generally,
price is mentioned in advertising when it is low, not high. However, we believe it is not
just the fact that advertising mentions prices or expands the consideration set that
determines whether advertising is promoting (increasing) price sensitivity. The
discussion needs to be put into the context of a causal explanation for why and how price
and non-price advertising come to dominate different markets.
In particular, it seems to us that the breadth of retailer availability is the primary
determinant of the degree to which retailers focus on price or other marketing efforts.
Having the same product available in many different retail outlets encourages price
competition, especially when consumers regard the different outlets as similar. If a
retailer were to enjoy a local monopoly on strong brands such as Heinz Ketchup, Tide
detergent, or Tylenol, advertising that increased demand for these products would likely
be reflected in higher prices (whether or not price is mentioned or competing brands are
included in the consideration set). Of course, manufacturers do not have exclusive or
selective distribution policies for these products and, as a result, these brands are often
31
sold by retailers at very low or even negative margins. Many scholars fail to recognize
the essential role of broad distribution in creating the conditions for price competition at
retail. The key point is that the moderating effect of manufacturers’ distribution policies
determine whether retailers will be able to use increases in demand created by advertising
to raise their own selling prices and margins. These distribution policies include
promotional policies and allocation of production capacity; even products with broad
distribution, but insufficient supply, will result in retailers charging higher prices to
exploit the shortage.
Directions for further research
Based on the forgoing discussion, we believe that several directions can be
pursued to shed further light on the impact of advertising on price.
1. A key question that remains unresolved is whether the price of unadvertised
brands is being forced down by the price ceiling of advertised brands, or
whether on the contrary it is pulled up.
2. Further development of approaches for measurement and comparison of
absolute prices—the height of the price band—and lowest prices are required.
As noted above, one possibility could be measures of profits that allow for the
risk and the cost of investments in new product development. Another
possibility might be the change in absolute price over time, particularly before
and after major changes in the marketing environment for the category, such
as deregulation or availability of a radical new technology. Comparisons of
absolute or lowest prices across countries or large regions might also be useful
(in effect a meta-dispersion measure).
32
3. The forgoing arguments require the support of empirical study of both the
effects of store format on relative prices, and the effects of manufacturer
distribution policy on relative and absolute prices.
4. Early on we noted that we needed to limit the scope of this analysis.
Extending the analysis to include the long-term impact of advertising in
enabling new product development and diffusion would also be valuable.
5. As we noted above in passing, instead of studying the impact of advertising on
price for consumer welfare in the aggregate, it would be interesting to study
this and similar questions through the lens of distributive justice, with savings
to the less well-off segments of the population valued more than the identical
savings to the more well-off segments.
6. Finally, it would be valuable to revisit why this question is important in
today's context of building strong global brand with means other than
traditional advertising. Is it really advertising or strong brands that concern
public policy and consume welfare issues?
If research efforts are focused on the impact of advertising on absolute price, and
if due attention is paid to the impact of intermediaries, we believe that a significant
improvement can be made in our understanding of the relationship between advertising
and competition.
ENDNOTES
1 Price-quality correlation data needs to be “augmented by data on the variance in price and quality,” and “frontier measures of efficiency will measure the variance in consumer surplus only in the unlikely case of there being a perfect correspondence between the efficiency frontier and the consumer’s valuation of each alternative.” (177)
33
2 In all cases we compared only Extra Strength acetaminophen caplets, to maintain consistency. We did not include variations in strength (e.g. Regular Strength) or in delivery vehicle (e.g. gelcaps or tablets).
REFERENCES
Ailawadi, K., P. W. Farris and E. Shames (1999). “Trade promotion: an essential part of
pricing and selling through resellers.” Sloan Management Review 41(1).
Albion, Mark S. and Paul W. Farris (1987). Manufacturer Advertising and Retailer Gross
Margins. Advances in Marketing and Public Policy. P. Bloom, JAI Press.
Borden, Neil H. (1942). The Economic Effects of Advertising. Chicago, Richard H. Irwin.
Brown, Mark G., Jonq-Ying Lee and Thomas H. Spreen (1996). “The impact of generic
advertising and the free rider problem: A look at the US orange juice market and
imports.” Agribusiness 12(4): 309-317.
Brynjolfsson, Erik and Michael D. Smith (1999). Frictionless Commerce? A Comparison
of Internet and Conventional Retailers, MIT Sloan School of Management.
Buzzell, Robert D. and Paul W. Farris (1977). Marketing Costs in Consumer Goods
Industries. Strategy + Structure = Performance. H. B. Thorelli. Bloomington, Indiana,
Indiana University Press.
Court, David, Thomas D. French, Tim I. McGuire and Michael Partington (1999).
“Marketing in 3-D.” McKinsey Quarterly(4).
Dickson, Peter R. and Alan G. Sawyer (1990). “The Price Knowledge and Search of
Supermarket Shoppers.” Journal of Marketing 54(3): 42-53.
Dorfman, Robert and Peter O. Steiner (1954). “Optimal Advertising and Optimal
Quality.” American Economic Review 44: 826-836.
Farris, Paul W. and Mark Albion (1981). “Determinants of the Advertising-to-Sales
Ratio.” Journal of Advertising Research(February).
Farris, Paul W. and Robert D. Buzzell (1979). “Variations in Advertising Intensity: Some
Cross-Sectional Analyses.” Journal of Marketing 43(Fall): 112-122.
Farris, Paul W. and David J. Reibstein (1979). “How price, expenditures and profits are
linked.” Harvard Business Review 57(November/December): 173-184.
Farris, Paul W. and David J. Reibstein (1997). Consumer prices and advertising.
Encyclopedic Dictionary of Business Ethics. P. H. Werhane and R. E. Freeman. Malden,
MA, Blackwell Publishers Inc.: 139-141.
Fournier, Susan (1995). Land Rover North America, Inc., Harvard Business School Case.
9-596-036.
Kanetkar, V, C. Weinberg and D. Weiss (1992). “Price sensitivity and television
advertising exposures: some empirical findings.” Marketing Science 11(4): 359-372.
Kaul, A and D. Wittink (1995). “Empirican generalizations about the impact of
advertising on price sensitivity and price.” Marketing Science 14(3): 151-161.
Lodish, Leonard M, Magid Abraham, Stuart Kalmenson, Jeanne Livelsberger, Beth
Lubkin, Bruce Richardson and Mary Ellen Stevens (1995). “How TV advertising works:
a meta-analysis of 389 real world split cable TV advertising experiments.” Journal of
Marketing Research 32(2): 125-140.
Mitra, A and J. Lynch (1995). “Toward a reconciliation of market power and information
theories of advertising effects on price elasticity.” Journal of Consumer Research 21(4):
644-660.
Monroe, K and A. Lee (1999). “Remembering versus knowing: issues in buyers'
processing of price information.” Academy of Marketing Science 27(2): 207-225.
Quelch, John A. (1986). General Electric Company: Consumer Incandescent Lighting,
Harvard Business School case. 2-587-014.
Ratchford, Brian, Jagdish Agrawal, Pamela E Grimm and Narasimhan Srinivasan (1996).
“Toward understanding the measurement of market efficiency.” Journal of Public Policy
and Marketing 15(2): 167-184.
Schmalensee, R (1981). “Output and Welfare implications of monopolistic third-degree
price discrimination.” American Economic Review 71(1): 242-247.
Steiner, R “Manufacturers' promotional allowances, free riders, and vertical constraints.”
Antitrust Bulletin 36(2): 383-411.
Steiner, R (1973). “Does advertising lower consumer prices?” Journal of Marketing
37(October): 19-26.
Steiner, R (1993). “The inverse association between margins of manufacturers and
retailers.” Review of Industrial Organization 8: 717-740.
Strenio, A (1996). “The Aspirin Wars.” Journal of Public Policy and Marketing 15(2):
319-321.
Vakratsas, D and T. Ambler (1999). “How Advertising Works: What do we really
know?” Journal of Marketing 63(January): 26-43.