Economics of Management Strategy BEE3027 Lecture 3 15/02/2008.

Economics of Management StrategyBEE3027

Lecture 3

15/02/2008

Recap

• Last week we looked at:– Property-rights motivation for existence of firms;

– Team production;

– Compensation schemes;

– Coordination problem in production.

This week

• We will look at:

• Strategic interaction in oligopolies:– The role of managers and strategic delegation.

• Advertising.

Advertising

• Advertising is an integral part of our lives.

• It is also one of the largest industries:– Global spending on advertising in 2005: $400bn

• Economists see advertising as a means to transmit information about a good or service.

• However, there are 2 key aspects to it:– Information receivers don’t pay for information;– Information is transmitted by the seller.

Advertising

• Advertising expenditure is usually measured as the ratio of adv expenditure to sales.

• This ratio varies drastically across industries:

• We will look at advertising from two different perspectives:– Persuasive advertising;– Informative advertising.

Persuasive Advertising

• Models of persuasive advertising assume that advertising enhances consumer preferences for a given product.

• Hence, higher expenditures on advertising result in increased demand for a product.

• Typically you’d think of the effect of advertising as a rightward shift in the demand curve.

Persuasive Advertising

Persuasive Advertising

• Firm must balance out the effects on demand of a shift in demand due to advertising expenditures and the impact of a change in price.

• The balance is found when

• Markets sensitive to advertising will have higher advertising-to-sales ratios

PQ

AQ

PQ

A

,

,

Informative advertising

• In the real world, there are a number of different products which cater to our needs.

• However, it is difficult to know all the products out there and make an informed choice.

• Advertising can be seen as a means to inform consumers of the existence of a product.

• In this sense, it may be socially productive to engage in advertising activities.

Informative advertising

• Consider the case of a single consumer, in a market with a single good. – The price of this good is fixed at p.– The benefit the consumer gains from the good is m.

• Hence, the consumer’s utility function is:m – p if he purchases the good;

0 otherwise

Informative advertising

• There are two firms selling this product.– There are zero production costs

• Firms can only use advertising as a tool to boost sales.– Advertising has a cost equal to A

• Therefore, the consumer may receive a total of 0, 1 or 2 ads from the two companies.

Informative advertising

• If the consumer receives no ads, he will not buy the product.

• If the consumer only receives on ad, he will buy the product from that company.

• If the consumer receives both ads, he will pay p/2 to both firms.– This is equivalent to flipping a coin to determine

which firm to buy the product from.

Informative advertising

• Therefore, the payoff to firm i is:p – A if only firm i’s ad is received;

p/2 – A if both firms’ ads are received;

– A if firm i sends an ad but consumer does not receive it;

0 if firm i does not advertise

• The fact that firms create ads does not imply consumers will see them.

Informative advertising

• The probability that the consumer will see the ad is the same for both firms and is equal to δ, where 0 < δ < 1.

• So, the expected profit for firm i is:δ(1- δ)(p-A) + δ²(p/2-A) – (1- δ)A if 2 firms advertise;

δ(p-A) – (1-δ)A if only firm i advertises;

0 if firm i does not advertise.

Informative advertising

• What is the social optimal level of advertising?– The social planner wants to maximise consumer

surplus and total profit

• Expected welfare is:δ(2- δ )m – 2A if two firms advertise;

Δm – A if one firm advertises;

0 if no firm advertises

Informative advertising

• Suppose that p would be set to its maximum level, such that consumer surplus is zero– i.e. p = m– This way, welfare = profits and our analysis is made

much simpler!

• It is therefore socially optimal for two firms to advertise if:

δ(2- δ )p – 2A > δp – A p/A > 1/[δ(1- δ)]

Informative advertising

• So, there are combinations of p/A and δ in which:– It is profitable for each firm to advertise;– But where it is socially inefficient to do so.

Informative or persuasive?

• So far, we’ve covered two different approaches to advertising.

• These models assume that either:– Consumers are aware of the product, but need “convincing”; or– Consumers are unaware of the product, but would buy it once

they know about it.

• In reality, some consumers will not be informed, while others will.

• In the latter case, it is likely some consumers will prefer one product over others.

Targeted advertising

• The bottom line is that firms will be unable to successfully reach the entire set of consumers.

• Firms must instead target a subset of consumers for which their advertising appeals.– It is almost impossible to identify product attributes

which are universally appealing;– Advertising is costly, hence there will diminishing

returns to scale;– Having a differentiated product gives firms market

power, thus implicitly segmenting their demand.

Targeted advertising

• Consider 2 firms, 1 and 2 producing differentiated brands of the same product, brand 1 and brand 2.

• There are two types of buyers:– N inexperienced consumers;– E experienced consumers.

• E is divided into:– θ consumers who prefer brand 1;– (1-θ) consumers who prefer brand 2.

Targeted advertising

• In this model, a firm may either use:– Persuasive advertising, P, or– Informative advertising, I.

• P only affects inexperienced consumers. So if firm 1 chooses P:– If firm 2 chooses I, firm 1 gets N consumers;– If firm 1 also chooses P, both firms get N/2

consumers.

• I only affects experienced consumers. – If firm 1 chooses I, it gets θE consumers;– If firm 2 chooses I, it gets (1- θ)E consumers.

Targeted advertising

Firm 2

P I

Firm 1P N/2, N/2 N, (1- θ)E

I θE, N θE, (1- θ)E

Targeted advertising

• Any of the 4 outcomes can be an equilibrium of this game depending on certain market conditions.

• (P,P) is an equilibrium (i.e. firms only target inexperienced consumers) if:– N > E;

–

• (I,I) is an equilibrium (i.e. firms only target inexperienced consumers) if – E > 2N;

–

E

N

E

N

221

E

N

E

N 1

Targeted Advertising

• If brand 1 is unpopular among experienced users, firm 1 will use persuasive advertising and firm 2 will use informative advertising.

• (P,I) is an equilibrium if:

– }{2

1,minE

N

E

N

Targeted Advertising

• If brand 1 is sufficiently popular among experienced users, firm 1 will use informative advertising and firm 2 will use persuasive advertising.

• (I,P) is an equilibrium if

– }{ 1,2

maxE

N

E

N