[An updated version of this article can be found at Advertising in the 2nd edition.]
Economic analysis of advertising dates to the thirties and forties, when critics attacked it as a monopolistic and wasteful practice. Defenders soon emerged who argued that advertising promotes competition and lowers the cost of providing information to consumers and distributing goods. Today, most economists side with the defenders most of the time.
There are many different types of advertising—the 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 that firms convey in advertising is not systematically worse than the information volunteered in political campaigns or when we sell a used car to a stranger.
Modern economics views advertising as a type of promotion in the same vein as direct selling by salespersons and promotional price discounts. This is because it is easier to understand why advertising is used in some circumstances and not in others by looking at the problems firms face in promoting their wares, rather than by focusing on advertising as an isolated phenomenon.
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 at the turn of the 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 GNP has stayed relatively constant since the twenties at roughly 2 percent. More than half of that total is national, as opposed to local, advertising. In the eighties newspapers accounted for 26 percent of total advertising expenditures, magazines for 23 percent, television for 22 percent, radio for 7 percent, and miscellaneous techniques such as direct mail, billboards, and the Goodyear blimp for the remaining 22 percent. One popular argument in favor of advertising is, in fact, 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.
While aggregate expenditures on advertising have remained steady as a percentage of GNP, the intensity of spending varies greatly across firms and industries. 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. If a type of product is heavily advertised in the United States, it tends to be heavily advertised in Europe as well. Even within an industry, however, some firms will advertise more, others less. Among pharmaceutical manufacturers, Warner-Lambert's spending on advertising is over 30 percent of sales, while Pfizer's advertising-to-sales ratio is less than 7 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.
While persuasion and the creation of brand loyalty are often emphasized in discussions of advertising, 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 in selecting products, which often were unbranded. Today, consumer familiarity with branded products is one factor that makes it possible for far fewer retail employees to serve the same number of customers.
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 (the Marlboro man, for example) can be usefully thought of as something that customers demand along with the 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.
Advertising messages obviously can be used to mislead, but a heavily advertised brand name also 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, officials in the Soviet Union encouraged the use of brand names and trademarks even under central planning as a way of monitoring which factories produced defective merchandise and as a way of allowing consumers to inform themselves about products available from various sources.
Economic debate in the fifties 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 made consumers less sensitive to price, allowing firms that advertise to raise their prices above competitive levels. The purported link between advertising and monopoly became so widely accepted that in the sixties the U.S. attorney general proposed a tax on advertising.
Economic researchers addressed this issue by examining whether industries marked by heavy advertising were also more concentrated or had higher profits. The correlation between advertising intensity and industry concentration turned out to be very low and erratic from sample to sample, and it is largely ignored today. What's 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 received support from 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 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 find 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 prices of eyeglasses 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 allowed high-volume, low-cost retailers to communicate effectively with potential customers even if they could not mention price explicitly.
The importance of price advertising, however, apparently varies with the way the consumers typically obtain price information and make purchase decisions. An unpublished study by Al Ehrbar found that gasoline prices are significantly higher (about 6 percent, net of excise taxes) in communities that prohibit large price signs in gas stations.
In the past many professions such as doctors, lawyers, and pharmacists succeeded in getting state legislatures to implement complete or partial bans on advertising, preventing either all advertising or advertising of prices. Recent 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 curiously prohibited precisely the same disclosure before that. The federal government also banned all radio and television advertising of cigarettes beginning January 1, 1971. 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 introduced.
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.
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