Advertising

by George Bittlingmayer
About the Author
Economic analysis of advertising dates to the 1930s and 1940s, when critics attacked it as a monopolistic and wasteful practice. Defenders soon emerged who argued that advertising promotes competition and lowers the costs of providing information to consumers and distributing goods. Today, most economists side with the defenders most of the time.

Advertising comes in many different forms: grocery ads that feature weekly specials, “feel-good” advertising that merely displays a corporate logo, ads with detailed technical information, and those that promise “the best.” Critics and defenders have often adopted extreme positions, attacking or defending any and all advertising. But, at the very least, it seems safe to say that the information firms convey in advertising is not systematically worse than the information volunteered in political campaigns or used car ads.

Modern economics views advertising as a type of promotion, in the same vein as direct selling by salespersons and promotional price discounts. If we focus on the problems firms face in promoting their wares, rather than on advertising as an isolated phenomenon, it is easier to understand why advertising is used in some circumstances and not in others.

Scope

While advertising has its roots in the advance of literacy and the advent of inexpensive mass newspapers in the nineteenth century, modern advertising as we know it began early in the twentieth century with two new products, Kellogg cereals and Camel cigarettes. What is generally credited as the first product endorsement also stems from this period: Honus Wagner’s autograph was imprinted on the Louisville Slugger in 1905.

Advertising as a percentage of GDP has stayed relatively constant since the 1920s, at roughly 2 percent. About 60 percent of advertising is national rather than local. Table 1 shows national and local expenditures since 1940. In 2002, newspapers accounted for some 19 percent of total advertising expenditures; magazines for 5 percent; broadcast and cable television for 23 percent; radio for 8 percent; direct mail for 19 percent; and miscellaneous techniques such as yellow pages, billboards, and the Goodyear blimp for the remaining 27 percent. Internet advertising accounted for 2 percent of total advertising expenditures.

One popular argument in favor of advertising is that it provides financial support for newspapers, radio, and television. In reply, critics remark that advertiser-supported radio and television programming is of low quality because it appeals to those who are easily influenced by advertising. They also charge that advertiser-supported newspapers and magazines are too reluctant to criticize products of firms that are actual or potential advertisers.


Table 1 Advertising Expenditures (billions $)

National Local Total % of GDP

1940 1.2 0.9 2.1 2.11
1950 3.3 2.4 5.7 1.98
1960 7.3 4.7 12.0 2.28
1970 11.4 8.2 19.6 1.89
1980 29.8 23.7 53.5 1.91
1990 73.6 56.3 130.0 2.24
2000 151.7 95.8 247.5 2.52
2002 145.7 91.8 237.4 2.27

Sources: Statistical Abstract of the United States, 1987, 537; and 2002, 438 and 772; U.S. Historical Statistics, Colonial Times to 1970, Series T444; and Advertising Age, May 6, 1991, p. 16. Numbers may not add up due to rounding.

While aggregate expenditures on advertising have remained steady as a percentage of GDP, the intensity of spending varies greatly across firms and industries (see Table 2). Many inexpensive consumer items, such as over-the-counter drugs, cosmetics, and razor blades, are heavily advertised. Advertising-to-sales ratios also are high for food products such as soft drinks, breakfast cereals, and beer. And there is remarkable stability in this pattern from country to country. A type of product that is heavily advertised in the United States tends to be heavily advertised in Europe, as well. Even within an industry, however, some firms will advertise more than others. Among pharmaceutical manufacturers, for example, Merck and Bayer spend less than 5 percent of sales on advertising, while Pfizer spends in excess of 12 percent.

The differences among industries, while stable, are deceptive. For example, automakers typically spend only 1 to 2 percent of sales on advertising, but their products are heavily promoted by the sales staffs in dealer showrooms. Similarly, industrial products are not heavily advertised because trade fairs and point-of-sale promotion are often more cost-effective than advertising. Products with relatively few customers may not be advertised at all or advertised solely in specialized publications.

Economic Function

While discussions of advertising often emphasize persuasion and the creation of brand loyalty, economists tend to emphasize other, perhaps more important, functions. The rise of the self-service store, for example, was aided by consumer knowledge of branded goods. Before the advent of advertising, customers relied on knowledgeable shopkeepers for help in selecting products, which often were unbranded. Today, consumer familiarity with branded products is one factor making it possible for far fewer retail employees to serve the same number of customers.


Table 2 Advertising-to-Sales Ratios, Top Twenty Industries, 2003

Loan brokers 38.4
Health services 32.5
Distilled and blended liquor 14.9
Miscellaneous publishing 12.9
Sugar and confectionery products 11.7
Soap, detergent, and toilet preparations 11.3
Amusement parks 10.7
Food and kindred products 10.2
Special cleaning and polishing preparations 9.7
Knitting mills 9.6
Television broadcast stations 9.3
Beverages 9.2
Water transportation 8.8
Malt beverages 8.5
Heating equipment and plumbing fixtures 8.4
Motion picture and video tape production 8.4
Rubber and plastic footwear 8.4
Games, toys, children’s vehicles, except dolls 8.2
Dolls and stuffed toys 7.8
Cable and other pay TV services 7.7

Source: Advertising Age, online at: http://www.adage.com/page.cms?pageId=1013.
Note: Top twenty industries among the two hundred industries spending the most on advertising.

Newly introduced products are typically advertised more heavily than established ones, as are products whose customers are constantly changing. For example, cosmetics, mouthwash, and toothpaste are marked by high rates of new product introductions because customers are willing to abandon existing products and try new ones. Viewed this way, consumer demand generates new products and the advertising that accompanies them, not the other way around.

In a similar vein, “noninformative,” or image, advertising can be usefully thought of as something that customers demand along with the product. Customers often want to see themselves as athletic, adventuresome, or spontaneous, and vendors of beer, cars, and cell phones bundle the image and the physical product. When some customers are unwilling to pay for image, producers that choose not to advertise can supply them with a cheaper product. Often, the same manufacturer will respond to these differences in customer demands by producing both a high-priced, labeled, heavily advertised version of a product and a second, low-priced line as an unadvertised house brand or generic product. In baked goods, canned goods, and dairy products, for example, some manufacturers sell one version under their own nationally known label and another slightly different version under a particular grocery chain’s private label.

Advertising messages obviously can be used to mislead, but a heavily advertised brand name limits the scope for deception and poor quality. A firm with a well-known brand suffers serious damage to an image that it has paid dearly to establish when a defective product reaches the consumer (see brand names). Interestingly, even under central planning, officials in the Soviet Union encouraged the use of brand names and trademarks in order to monitor which factories produced defective merchandise and to allow consumers to inform themselves about products available from various sources.

Monopoly

Early opinion among many economists was summarized by Henry Simons, who wrote in 1948 that “a major barrier to really competitive enterprise and efficient service to consumers is to be found in advertising—in national advertising especially, and in sales organizations which cover great national and regional areas.” Economic debate in the 1950s focused on whether advertising promotes monopoly by creating a “barrier to entry.” Heavy advertising of existing brands, many economists thought, might make consumers less likely to try new brands, thus raising the cost of entry for newcomers. Other economists speculated that advertising makes consumers less sensitive to price, allowing firms that advertise to raise their prices above competitive levels.

Economic researchers addressed this issue by examining whether industries marked by heavy advertising were also more concentrated (see industrial concentration) or had higher profits. The correlation between advertising intensity and industry concentration turned out to be very low and varied from sample to sample, and it is largely ignored today. What is more, early research found that high levels of advertising in an industry were associated with unstable market shares, consistent with the idea that advertising promoted competition rather than monopoly.

The idea that advertising creates monopoly was supported by studies that found high rates of return in industries with high levels of advertising. As other economists pointed out, however, the accounting rates of return used to measure profits do not treat advertising as an asset. Consequently, measured rates of return—income divided by measured assets—will often overstate profit rates for firms and industries with heavy advertising. Subsequent work showed that when attention is restricted to industries with relatively small bias in the accounting numbers, the correlation between rates of return and amount of advertising disappears. A lucky by-product of the advertising-and-profits dispute were studies that estimated depreciation rates of advertising—the rates at which advertising loses its effect. Typically, estimated rates are about 33 percent per year, though some authors have found rates as low as 5 percent.

Contrary to the monopoly explanation (and to the assertion that advertising is a wasteful expense), advertising often lowers prices. In a classic study of advertising restrictions on optometrists, Lee Benham found that eyeglass prices were twenty dollars higher (in 1963 dollars) in states banning advertising than in those that did not. Bans on price advertising, but not on other kinds of advertising, resulted in prices nearly as low as in the states without any restrictions at all. Benham argued that advertising allows high-volume, low-cost retailers to communicate effectively with potential customers, even if they cannot mention price explicitly.

The importance of price advertising, however, apparently varies with the way consumers typically obtain price information and make purchase decisions. An unpublished study by Al Ehrbar found gasoline prices to be significantly higher (about 6 percent, net of excise taxes) in communities that prohibited large price signs in gas stations.

Regulation

In the past, many professionals such as doctors, lawyers, and pharmacists succeeded in getting state legislatures to implement complete or partial bans on advertising in their professions, preventing either all advertising or advertising of prices. In recent decades court decisions have overturned these restrictions. At the federal level, the U.S. Federal Trade Commission has jurisdiction over advertising by virtue of its ability to regulate “deceptive” acts or practices. It can issue cease-and-desist orders, require corrective advertising, and mandate disclosure of certain information in ads.

The Regulation of cigarette advertising has been particularly controversial. The Federal Trade Commission has required cigarette manufacturers to disclose tar and nicotine content since 1970, although it had prohibited precisely the same disclosure before that. Beginning January 1, 1971, the federal government also banned all radio and television advertising of cigarettes. While overall cigarette advertising expenditures dropped by more than 20 percent, per capita cigarette consumption remained unchanged for many years. Critics of the regulations maintain that it was the growing evidence of the harmful effects of smoking, rather than the reduction in advertising, that ultimately led to the smaller percentage of smokers in society. The critics also contend that the advertising ban may have slowed the rate at which low-tar cigarettes were used.

Governmental Advertising

Governments have funded or mandated advertising to reduce harmful behaviors such as smoking, drunk driving, and drug use. Researchers have not devoted much attention to such efforts. One exception is California’s Proposition 99, passed in 1988, which increased taxes on cigarettes from ten to thirty-five cents per package and earmarked 20 percent for educational programs, including an antismoking campaign. The one study that looked at this measure found that increased expenditures on antismoking measures were associated with declines in per capita cigarette sales.


About the Author

George Bittlingmayer is the Wagnon Distinguished Professor of Finance at the University of Kansas School of Business. He was previously an economist with the Federal Trade Commission.


Further Reading

Becker, Gary S., and Kevin M. Murphy. “A Simple Theory of Advertising as Good or Bad.” Quarterly Journal of Economics 108 (November 1993): 941–964.
Benham, Lee. “The Effect of Advertising on the Price of Eyeglasses.” Journal of Law and Economics 15 (October 1972): 337–352.
Borden, Neil H. The Economic Effects of Advertising. Chicago: Irwin, 1942.
Chaloupka, Frank J. “Public Policies and Private Anti-health Behavior.” American Economic Review 85 (May 1995): 45–49.
Comanor, William S., and Thomas A. Wilson. “Advertising and Competition: A Survey.” Journal of Economic Literature 17 (June 1979): 453–476.
Ekelund, Robert B. Jr., and David S. Saurman. Advertising and the Market Process. San Francisco: Pacific Research Institute for Public Policy, 1988.
Hu, The-Wei, Hai-Yen Sung, and Theodore E. Keeler. “The State Antismoking Campaign and the Industry Response: The Effects of Advertising on Cigarette Consumption in California.” American Economic Review 85 (May 1995): 85–90.
Landes, Elisabeth M., and Andrew M. Rosenfield. “The Durability of Advertising Revisited.” Journal of Industrial Economics 42 (September 1994): 263–276.
Rubin, Paul. “Regulation of Information and Advertising.” In Barry Keating, ed., A Companion to the Economics of Regulation. London: Blackwell, 2004.
Schmalensee, Richard. The Economics of Advertising. Amsterdam: North-Holland, 1972.
Telser, Lester. “Advertising and Competition.” Journal of Political Economy 72 (December 1964): 537–562.
Telser, Lester. “Some Aspects of the Economics of Advertising.” Journal of Business 41 (April 1968): 166–173.

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