By Dr. Hassan Shirvani–Advertising\u00a0is an important feature\u00a0of our daily economic life. \u00a0As\u00a0we\u00a0watch TV, listen to radio, read newspapers and magazines, and use social\u00a0media, we are constantly bombarded with advertisements. \u00a0For this\u00a0\u201cprivilege,\u201d\u00a0we are asked to pay some $325 billion per year,\u00a0roughly 2 percent of our annual national income. \u00a0Given this heavy demand of advertising on our scarce resources,\u00a0economists have long struggled to justify the need for advertising as well as to determine its efficient level.\u00a0 This post reviews some of their findings.<\/p>\n
Role of Advertising<\/strong><\/p>\n Prior to the 1930s, economists had no systematic theory of the role of advertising in the economy. \u00a0Indeed, given their assumptions of perfectly competitive\u00a0markets, in which\u00a0a large number of small\u00a0firms could sell\u00a0their identical product\u00a0at a\u00a0fixed\u00a0price to a well-informed group of buyers, there was hardly any need for advertising. \u00a0In\u00a0reality, of course, markets were not perfectly competitive, but rather dominated by\u00a0large monopolistic firms with considerable market powers. \u00a0Under these conditions, many businesses could and did boost their sales and profits through aggressive advertising campaigns. <\/p>\n Given this\u00a0fact,\u00a0some\u00a0economists in the 1930s\u00a0began to\u00a0modify\u00a0their\u00a0simplistic\u00a0models to\u00a0incorporate\u00a0the new realities of\u00a0modern industrial\u00a0economies\u00a0with their\u00a0powerful corporations.\u00a0\u00a0In these new models,\u00a0information was a scarce and valuable commodity and\u00a0producers had to continuously differentiate their products from those of their\u00a0competitors to survive. \u00a0Thus, economists began to gradually acknowledge and examine the growing importance of advertising in modern economic life.<\/p>\n Perhaps the most important\u00a0contribution\u00a0of advertising\u00a0is to provide information on new products and their prices, regardless of whether these products are designed to meet legitimate needs or wanton wants.\u00a0\u00a0There 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,\u00a0redundant. \u00a0In addition, whenever several firms engage\u00a0simultaneously\u00a0in advertising for similar products, the additional information may create confusion and, hence, paralysis for buyers. \u00a0At the same time, to the extent that some advertising by rival firms may be mutually offsetting,\u00a0many businesses may tend to exceed their informationally optimal levels of advertising.<\/p>\n Given these difficulties, some economists have tended to emphasize another aspect of advertising, to wit, its role in shaping\u00a0the tastes\u00a0of buyers.\u00a0\u00a0According to this view, most advertising is not meant to\u00a0inform, but\u00a0rather\u00a0to persuade, that is, to shape the preferences\u00a0of buyers.\u00a0\u00a0By doing so, advertising can reduce price elasticities of demand for the advertised products and, hence, render buyers less sensitive to price increases.\u00a0 If true, this may help explain why many businesses keep advertising for\u00a0essentially the same products for many years. \u00a0The main objective seems to be creating brand loyalties, where\u00a0brand names are often equated by many buyers with higher quality.<\/p>\n In addition, brand names for the existing firms can also raise\u00a0barriers\u00a0to entry for\u00a0potential\u00a0competitors.\u00a0\u00a0In this light, it is clear that advertising can have important implications for the competitive nature of the markets in which businesses operate. \u00a0If advertising does establish brand names and, hence,\u00a0boost sales, it can also increase market shares and, thus,\u00a0greater\u00a0economic\u00a0powers\u00a0for\u00a0the\u00a0successful firms. \u00a0This in turn can increase economic concentration, as more successful firms will now have both the\u00a0incentives and\u00a0the\u00a0resources to advertise even more,\u00a0often to the detriment of their smaller rivals.\u00a0\u00a0\u00a0In 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.<\/p>\n Is Advertising Wasteful?<\/strong><\/p>\n 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.\u00a0 However, economists have shown that there is an even more fundamental reason why advertising is generally excessive and inefficient.\u00a0 This is based on the fact that advertising is usually offered not as an independent product but jointly with other advertised goods and services.\u00a0 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.\u00a0 In particular, the price of advertising would have reflected its true cost to society.\u00a0 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).<\/p>\n Under these conditions, many consumers would tend to over-indulge in the consumption of advertising, as they usually do for any subsidized product.\u00a0 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.\u00a0 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.\u00a0 In other words, advertising is a kind of \u201closs leader,\u201d 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.<\/p>\n Like other loss leaders, however, advertising can create a couple of problems.\u00a0 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.\u00a0 This, of course, can decrease the demand for such products.\u00a0 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.\u00a0 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.<\/p>\n Conclusion<\/strong><\/p>\n There is no question that some advertising can be informative and, thus, highly desirable. \u00a0However, advertising can also be redundant, deceptive, and wasteful of scarce resources. \u00a0This is particularly the case if we regard advertising as a bundled commodity offered free of charge in combination with other products. \u00a0Under these conditions, the excessive production of advertising can replace the production of more useful products.<\/p>\n <\/p>\n Hassan Shirvani, Ph.D.<\/a>
\nProfessor Cullen Foundation Chair in Economics<\/p>\n