By Dr. Hassan Shirvani–Advertising is an important feature of our daily economic life.  As we watch TV, listen to radio, read newspapers and magazines, and use social media, we are constantly bombarded with advertisements.  For this “privilege,” we are asked to pay some $325 billion per year, roughly 2 percent of our annual national income.  Given this heavy demand of advertising on our scarce resources, economists have long struggled to justify the need for advertising as well as to determine its efficient level.  This post reviews some of their findings.

Role of Advertising

Prior to the 1930s, economists had no systematic theory of the role of advertising in the economy.  Indeed, given their assumptions of perfectly competitive markets, in which a large number of small firms could sell their identical product at a fixed price to a well-informed group of buyers, there was hardly any need for advertising.  In reality, of course, markets were not perfectly competitive, but rather dominated by large monopolistic firms with considerable market powers.  Under these conditions, many businesses could and did boost their sales and profits through aggressive advertising campaigns.

Given this fact, some economists in the 1930s began to modify their simplistic models to incorporate the new realities of modern industrial economies with their powerful corporations.  In these new models, information was a scarce and valuable commodity and producers had to continuously differentiate their products from those of their competitors to survive.  Thus, economists began to gradually acknowledge and examine the growing importance of advertising in modern economic life.

Perhaps the most important contribution of advertising is to provide information on new products and their prices, regardless of whether these products are designed to meet legitimate needs or wanton wants.  There is certainly something to be said for this informational aspect of advertising, were it not for the fact that much of it is provided by interested parties, and some of it seems repetitive and, hence, redundant.  In addition, whenever several firms engage simultaneously in advertising for similar products, the additional information may create confusion and, hence, paralysis for buyers.  At the same time, to the extent that some advertising by rival firms may be mutually offsetting, many businesses may tend to exceed their informationally optimal levels of advertising.

Given these difficulties, some economists have tended to emphasize another aspect of advertising, to wit, its role in shaping the tastes of buyers.  According to this view, most advertising is not meant to inform, but rather to persuade, that is, to shape the preferences of buyers.  By doing so, advertising can reduce price elasticities of demand for the advertised products and, hence, render buyers less sensitive to price increases.  If true, this may help explain why many businesses keep advertising for essentially the same products for many years.  The main objective seems to be creating brand loyalties, where brand names are often equated by many buyers with higher quality.

In addition, brand names for the existing firms can also raise barriers to entry for potential competitors.  In this light, it is clear that advertising can have important implications for the competitive nature of the markets in which businesses operate.  If advertising does establish brand names and, hence, boost sales, it can also increase market shares and, thus, greater economic powers for the successful firms.  This in turn can increase economic concentration, as more successful firms will now have both the incentives and the resources to advertise even more, often to the detriment of their smaller rivals.   In addition, while the increased economic concentration can sometimes reduce costs through greater production efficiencies, such cost savings are frequently used for more advertising, or higher profits, rather than passed to consumers as lower prices.

Is Advertising Wasteful?

The preceding should make it clear that to the extent that advertising tends to be anti-competitive, manipulative, and redundant, it can be both deleterious and wasteful.  However, economists have shown that there is an even more fundamental reason why advertising is generally excessive and inefficient.  This is based on the fact that advertising is usually offered not as an independent product but jointly with other advertised goods and services.  If advertising as a source of information were offered as a separate product, such as in the form of various consumer reports or investment newsletters, then the demand and supply for advertising would have possibly determined both its correct price and optimal quantity.  In particular, the price of advertising would have reflected its true cost to society.  In reality, of course, most advertising is offered either for free or at a negative price (such as when consumers are offered free TV programming as a bribe for encouraging them to watch TV commercials).

Under these conditions, many consumers would tend to over-indulge in the consumption of advertising, as they usually do for any subsidized product.  In addition, given the complementarity between advertising and the advertised products, if buyers consume more advertising, they will also tend to consume more of the advertised products.  This is not unlike the situation in which when consumers buy more coffee, they also tend to buy more cream, as coffee and cream are complementary goods.  In other words, advertising is a kind of “loss leader,” such as observed in many supermarkets when some consumer staples, such as sugary drinks, are sold at a loss, with the expectation that these losses will be more than covered by the increased sales and profits on other goods.

Like other loss leaders, however, advertising can create a couple of problems.  First, if the consumers of advertisements refuse to buy the advertised products, then the advertising costs will be imposed in the form of higher prices on those buyers who do.  This, of course, can decrease the demand for such products.  Second, just like the case with unhealthy beverages, free advertising can encourage overproduction of mostly useless commercials at the expense of other socially useful goods and services.  It is partly for these reasons, just to cite one example, that the American Medical Association has recently called for the ban of all prescription drugs commercials.

Conclusion

There is no question that some advertising can be informative and, thus, highly desirable.  However, advertising can also be redundant, deceptive, and wasteful of scarce resources.  This is particularly the case if we regard advertising as a bundled commodity offered free of charge in combination with other products.  Under these conditions, the excessive production of advertising can replace the production of more useful products.

 

Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics

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