How advertising may shift purchases between firms and industries - Dissertation Example

HOW ADVERTISING MAY SHIFT PURCHASES BETWEEN FIRMS AND INDUSTRIES WITHOUT AFFECTING CONSUMER SAVING AND AGGREGATE CONSUMPTION Advertising and Consumption In economic literature, the word advertising has several definitions and one of them states that, “Advertising is one of the three forms of demand creation (the other two being personal selling and sales promotion): it is any paid form of non-personal presentation and promotion of goods or services by an identified sponsor. It is a form of selling and it urges people to buy goods and services or to accept a point of view. It seeks to make people aware of things they need and to make them want these things. It introduces new products and describes new uses and improved features of familiar ones” (Dirken and Kroeger, 1973). From the stand point of industrial economics, it has been described as a form of product differentiation wherein firms communicate to consumers what goods and services they have to sell. Lipczynski and Wilson (1998) characterised it as “the most common method of strategic product differentiation: by using advertisements to provide information and convey persuasive messages, producers can create or exaggerate differences between goods and services; over the longer term this can be used to build up brand image and ensure consumer loyalty.” As far as economic literature is concerned, advertising is either informative or persuasive. Informative advertising simply describes the features of the product, and is extremely valuable in providing consumers with sufficient information enabling them to create or formulate informed choices and prudent decisions with regards to the goods and services they demand. This need for informative advertising can be traced back to microeconomics foundations – as it is, asymmetric information embodies one of the market failures in neo-classical approach. In a perfect competition with no uncertainty, in fact, information is perfect and there is no need for advertising: buyers and sellers have perfect knowledge of market conditions. But when some element of asymmetry is being introduced, the situation changes. Akerlof (1970) contended that if customers do not have adequate information to differentiate and discriminate between low and high quality goods and services, a situation can crop up where both types of products are displayed and sold at similar prices (classical moral hazard framework). Moraga-Gonzales (2000) makes valuable contribution in this arena by offering a model of informative advertising that diminishes problems for consumers who are confronted with the task of collecting information on potential purchases. From a theoretical viewpoint, therefore, informative advertising is useful in easing problems that stemmed from a market with incomplete information. On the other hand, persuasive advertising was conceptualised to modify, alter and twist consumers’ tastes. It warps the information that consumers receive, sometimes confusing them or worse, misleading them, making it very hard for them to make informed choices. As it is, basic consumer theory is founded on utility functions, and utility itself is characterised as the satisfaction drawn from the ownership of consumption goods and services. These goods are essential as they gratify the needs and wants of the individual. These physical and psychological needs are known as “preferences,” and these are believed to be given and to change slowly over time. Persuasive advertising is aimed at affecting and modifying consumers’ preferences. Economic literature is equally divided on the informative or persuasive nature of advertising. Marshall (1927) calls it, constructive advertising that is, these are “measures designed to draw attention to opportunities for buying and selling” and combative advertising which, according to Marshall, involves social wastes. The conventional notion of advertising exemplified in the writings of Kaldor (1950), Bain (1956), Galbraith (1958, 1967), and Comanor and Wilson (1974) is predisposed to a negative stance of its expediency. The whole contention is that advertising plays a role in bending consumer preferences, whereby consumers are convinced and influenced to buy products that are heavily promoted, in consequence, there exist the exploitation of market power by charging higher prices for branded products. Nawaz (1997) encapsulates the whole argument by saying, “The goal of persuasive advertising is to change customers’ perceptions of a product. If persuasive advertising works, it means that a branded product is considered in some non-tangible way to be different to its rivals. If successful, therefore, persuasive advertising may generate brand loyalty – customers may be unwilling to switch to competitors’ products if they are convinced that their preferred brand offers something that no other product would be able to provide.” In like manner, Shepard (1997) noted that “persuasive advertising interferes with the exercise of innate preferences; it alters choices away from the efficient lines that consumer sovereignty would yield. Thus persuasive image instilling advertising is largely a form of economic waste.” Here Shepard talks about the exact concept -- advertising as social waste -- that Marshall mentioned many years ago. The first one to underscore the probability of advertising increasing effective demand (and not merely swapping demand from one source of supply to another) was Rothschild (1942). Nevertheless, he also declared that it is utterly fruitless and impossible to try a quantitative estimate of the effects of total advertising on aggregate consumption. Alternatively, the standpoints espoused by writers such as Stigler (1961), Telser (1964), Nelson (1974a, b, 1975, 1978) and Littlechild (1982) maintained that advertising provides consumers with useful data which permits them to make judicious and intelligent choices. With this view, advertising plays a vital function in ascertaining the competent and effective distribution of resources in the economy. At the same time, Stigler (1961) claims that consumers carry out a search process in the pursuit of knowledge to make decisions. In so doing the consumer incurs costs in the form of wages or leisure time foregone, nonetheless, though each minute of search entails costs, it also carries with it an advantage in the form of increased knowledge as consumers discover the firms offering products at low prices. This process can be analysed in the perspective of cost/benefits analysis, likewise, the process of consumer search is apt to continue for as long as the marginal benefits of the search exceed the marginal costs, meaning, the consumer will continue to collect information as long as increased knowledge obtained from the search is not prevailed over by the costs. Additionally, Stigler underscores the fact that advertising reduces the costs of acquiring information. In other words, it is easier for the consumer to acquire information on the price and quality of products through advertisements than to engage in a protracted search process to collect this information by himself. “Advertising is among other things, a method of providing potential buyers with knowledge of the identity of sellers. It is clearly an immensely powerful instrument for the elimination of ignorance – comparable in force to the use of the book instead of the oral discourse to communicate knowledge” (Stigler, 19___, p.182). Telser (1964) on the other hand, stressed the functions performed by informative advertising: (1) identifies the existence of sellers; (2) makes out the vital qualities and attributes of different products and services accessible to consumers; (3) brings buyers and sellers together by moderating or trimming down the amount of time and costs that buyers incur searching for available goods and services. This assists in the proficient allocation of resources and paves the way for higher levels of welfare in the economy. Taken as a whole, Telser maintains that with the dearth of informative advertising, the sensible consumer would have inadequate information to make consumption choices. Nelson (1974a) censured the opinion that advertising twists consumer preferences. According to Nelson, “consumers are not completely helpless pawns in the hands of greedy businessmen. Though they have far less than perfect information, consumers have far more than zero information. “Nelson further argued that the extent to which advertising provides information principally relies on whether the goods concerned can be categorised as search goods -- commodities which can be scrutinised by either touch or sight before its purchase, such as clothes, carpets, shoes or experience goods, the ones which must be used so that an evaluation can be made, such as food, CDs, university courses, etc. Nelson maintains that advertising is apt to be informative for search goods since consumers can easily assess quality prior to purchase. Because of this, advertising expenditure will be lower for search goods, rather than for experience goods. Nelson (1974b) established that advertising expenditure on experience goods is likely to be three times higher than those on search goods. Nevertheless, consumers do have some control over their consumption of experience goods. Nelson’s (1974a) line of reasoning elucidates that “repeat purchases of the brands they like is the major source of control that consumers have over the market for experience goods. However, experimenting with unknown brands is a fairly expensive way for consumers to learn about the qualities of goods. Whenever possible, consumers seek to make their experiments less costly. One of the ways they do this is to choose their experiments guided by the recommendations of relatives and friends or of consumers magazines.” To evaluate whether advertising informs consumers on price, quality, contents, performance, availability, guarantees, taste, etc., Resnick and Stern (1977) developed a number of criteria to make the assessment. They argued that advertising can be considered as informative if they included one or more of the above features. To test this, they tested 378 advertisements. Of these, only 49.2% were viewed as informative. However, these results were sensitive to any changes in assumptions. They noted that if the criterion had been the communication of three different information cues, only 1% of the total sample, would have been informative. This conclusion generated a substantial body of research, most of which confirmed Resnick and Stern’s findings. Abernethy and Franke (1996) studied and investigated a sample of 91.438 advertisements, and they discovered an average number of cues of 2.04. The percentage of advertisement found to provide one, two, or three information cues were 84%, 58% and 33% respectively. They were also able to establish the fact that advertising media, outdoor and TV advertising contained the least amount of useful data while magazine and radio provided more information. Nonetheless, the fact that population of consumers is not equally spread across those media wasn’t considered. Without doubt, TV advertising is the most effective one, and thus, in order to evaluate the total impact of “imperfections” in advertising, such examination should have included some sort of “weights” to distinguish among media. Providing for a theoretical analysis of the effects of advertising on consumption in a microeconomic context, Selvanathan (1995) obtained demand equations from the theory of the utility-maximizing consumer which include advertising variables. The analysis is extremely complicated and wholly depends on advanced mathematical tools; however, he came to some very interesting conclusions about the link between the effects of advertising on consumption and the conventional substitution effect (he maintained that the former can only cause the latter). Basically, it is hard to make a clear-cut distinction between advertising that informs and advertising that persuades. Kizner (1997) then concludes: “To interpret advertising effort as primarily designed to persuade consumers to buy what they really do not want, raises an obvious difficulty. It assumes that producers find it more profitable to produce what consumers do not want, and then to persuade them to buy it, with expensive selling campaigns, rather than to produce what consumers do already in fact want (without need for selling effort).” Relationship of Aggregate Consumption and Advertising Keynes (1936) took it for granted that current consumption expenditure is a highly dependable and stable function of current income. He likewise maintained that an essential psychological rule of any modern community is that, when its real income increased, it will not increase its consumption by an equal absolute amount and that as a general rule, a greater proportion of income is saved as real income increases. Basically, the proportion of income saved correspondingly increases with income. Keynes acknowledged that windfall changes in capital values, substantial change in the rate of interest as well as changes in the distribution of income may have a significant influence on the propensity to consume, recognising also that due to habit persistence and slow adjustment, the long-run marginal propensity to consume was likely to be larger than the short-run propensity. This explains the fluctuation of the propensity to consume over the business cycle. Given the level of income and the major objective factors affecting the propensity to consume, the amount saved will depend on a number of subjective and social incentives which Keynes calls the motives of Precaution, Foresight, Calculation, Improvement, Independence, Enterprise, Pride, Avarice, Enjoyment, Short-sightedness, Generosity, Miscalculation, Ostentation and Extravagance. Keynes further implied that because of the social and economic background of these motives (which included institutions, habits, expectations, distribution of wealth etc.) change slowly and the short-period influence of the objective factors is often of secondary importance, meaning, “we are left with the conclusion that short-period changes in consumption largely depend on changes in the rate at which income (measured in wage-units) is being earned and not on changes in the propensity to consume out of a given income.” This first initial theoretical contribution triggered empirical work; after some studies that seemed to critically confirm Keynes’s hypothesis, after the Second World War, the experience underlined the inadequacy of a consumption function relating consumption (or savings) solely to current income. This stimulated a number of more complex hypothesis. Brady and Friedman (1947) suggested that a consumer unit’s consumption depends not on its absolute income but on its position in the distribution of income among consumer units in its community; they based their hypothesis, which was then called the relative income hypothesis exclusively on empirical data. Duesenberry (1949) based the same hypothesis on a theoretical structure, and his contribution is very relevant to the purposes of the study, besides being one of the most interesting alternatives to dominant mainstream consumption theories. Neo-classical approach assumes that individual preferences are independent of other individual’s consumption. Duesenberry challenged this belief, by arguing that individuals’ consumption is constantly driven by higher consumption by the so-called “demonstration effect”: he divided the utility index Ui = Fi (Ci1, Ci2,......Cin, Ai1, Ai2.......Ain) by a weighted average of the consumption expenditure of other individuals. As a result, individual average propensities to consume will depend upon his position in the income distribution: someone’s utility will be lower if they consume less than the average for the population. In other words, the division of income between consumption and saving depends on the individual’s relative rather than absolute income. He run a regression for United States in the period 1929-1941 to test this theory, and obtained reasonably good results. Why is Duesenberry’s approach so significant in the study? Because he was the first one to understand and formalise the intuition that the essence of the consumption problem was the dynamic desire for goods and services; the neo-classical approach said nothing about how such desires arise or how they change. According to Duesenberry, consumption decisions consisted of two elements: learning and habit forming. Habit patterns can be broken as a result of continual contact with superior goods; this frequency of contact is the driving force to higher consumption, “a drive sufficiently strong to account for the amount of work people do, and for the small size of their saving in the face of considerable insecurity.” For any individual, the frequency of contact with superior goods increases if other people’s consumption expenditure increases or if they are constantly “demonstrated” the superiority of other goods. Advertising fits perfectly in this framework, as consumers are continually bombarded with supposedly superior goods, which persuades them than their previous consumption bundle was below average; furthermore, advertising can also help reinforce habits so that consumers are encouraged to continue buying the same brand. The two processes described above are not contradictory as it might seem, since obviously the first effect -- drive to higher consumption -- is targeted at those consumers who are not already buying the product in question, whereas the second -- habits reinforcement-- is aimed at customers which are already using that product. Nonetheless, it is certainly true that consumers are continually “torn” between those two effects. In other words, advertising can establish an initial desire for consuming but also change these desires by making the consumer aware of superior goods as advertising itself provides the means for continual contact. However, Duesenberry denied the role of advertising in continually promoting higher consumption; he explicitly stated: “It seems doubtful that advertising accounts for the phenomenon before us”. The main departure from Keynesian consumption function occurred with the development of the permanent income and life cycle hypothesis, put forward by Modigliani and Brumerg (1954) and Friedman (1957). This theory assumes that individual’s consumption in a given period is not determined by his/her income in that period, but by his/her income over the entire lifetime. In other words, individual spreads consumption during his lifetime, subject to the constraint of the total lifetime resources at his disposal, so as to maximise his lifetime utility. Measuring the effect of advertising on consumption can be problematic. Economic theory provides some important insights into how econometric studies of cigarette advertising should be conducted. The most important economic aspect of advertising is the concept of diminishing marginal product. This concept is the basis of the advertising response function. Advertising response functions have been used in brand-level research (that is, research on products that are identifiable by a known name) to illustrate the effect of advertising on consumption at various levels of advertising. Economic theory suggests that, due to diminishing marginal product, advertising-response functions flatten out at some point. That is, after a certain point, consumption becomes ever less responsive to increases in advertising. Ultimately consumption is completely unresponsive to additional advertising. One important implication of diminishing marginal product is that, since media are not perfect substitutes, media diversification increases the effect of a given advertising budget. The industry-level advertising-response function at (a) national level and(b) market level. EMPIRICAL ANALYSIS, MODELING, AND RELATIONSHIPS Using the statistical package software known as Microstat, a trend was established showing direct relationships among the different variables involved in the data provided (Household Sector, Use of Disposable Income Account, Office for National Statistics). For expediency, the calculations were done and were based on data gathered within a twenty-year period, that is, from 1985-2005. Through the multiple correlation tool, which can test the significant effect of each variable, it can be shown that from 1985 to 2004, r = 0.979. This means that the degree of relationship existing among the different variables is very high; using another term, the obtained value 0.979 reveals a positive correlation, that direct relationship is present. Simply put, any increase in the value of any of the variables brings a corresponding increase in the values of the other variables in the data. Such conclusion of high degree of relationship within and among the variables is based on the Pearson Product Moment Correlation Coefficient Range of Values (Hinkle, Wiersman, and Jurs, 1982) shown below: 0.90 – 1.00 (-0.90 to -1.00) Very high positive (negative) correlation 0.70 – 0.90 (-0.70 to -0.90) High positive (negative) correlation 0.50 – 0.70 (-0.50 to 0.70) Moderate positive (negative) correlation 0.30 – 0.50 (-0.30 to 0.50) Low positive (negative) correlation 0.00 – 0.30 (0.00 to 0.30) Little, if any correlation The interpretation of the Pearson r is not a measure of causality, although a causal relationship may be present between two variables. To know whether the obtained correlation coefficient is significant, for example, that a real correlation exists or that the obtained r is not merely due to sampling variations, a t-test for testing the significance of r could be used. The formula is as follows: Where r = the obtained Pearson r value n = sample size t = 20.37 (computed value) t = 2.086 (tabular value) Advertising Activities, Consumer Behaviour and Consumption Patterns Model Does advertising increase consumption? If advertising doesnt increase consumption, why do companies take the time and shell out so much money to advertise? The answer is not really so complicated -- increase market share. To illustrate the point, let us take the alcohol industry and alcohol consumption. Alcohol is categorized under the “mature” product group which means that consumers are already aware of the product and its salient features. Thus, overall consumption is not affected significantly by advertising specific brands (Nelson, 1995). Instead of increasing total consumption, the goal of advertisers is to encourage and entice customers to swap from their usual brand to the brand being advertised at the same time create brand loyalty. Therefore, efficient and creative advertisers gain market share at the expense of others, who lose market share. They do not try to increase the total market for the product. An example can illustrate why they dont. The total retail value of beer produced annually in the U.S. is about $50 billion. If a producers advertising campaign increases its market share by 1%, its sales would increase by $500 million. However, if the total market for beer increased by 1%, a brand with a 10% share of the market would only experience a sales increase of $50 million. Clearly, a producer has a great incentive to increase market share, but little incentive (or ability) to increase the total market. For this reason, advertisers focus their efforts on established consumers. They seek to strengthen the loyalty of their own consumers and induce other consumers to try their brand. A study by the Federal Trade Commission found that there is “no reliable basis to conclude that alcohol advertising significantly affects consumption” (Crawford and Gramm, 1985, p.2). A United States Senate subcommittee reported in the Congressional Record that it could not find evidence to conclude that advertising influences non-drinkers to begin drinking or to increase consumption (Congressional Record, 1985). At the same time, the U.S. Department of Health and Human Services in its report to Congress concluded that there is no significant relationship between alcohol advertising and alcohol consumption. It did not recommend banning or imposing additional restrictions on advertising (U.S. Dept of Health and Human Services, 1990) while a University of Texas study of alcohol advertising over a 21-year period found that the amount of money spent on alcohol ads had little relationship with total consumption in the population (Wilcox, Franke and Vacker, 1994). Studies in both Canada and the United States find no significant link between restrictions on advertising and alcohol consumption (Ogbourne and Smart, 1976). The founding Director of the National Institute on Alcohol Abuse and Alcoholism recently pointed out that “There is not a single study - not one study in the United States or internationally - that credibly connects advertising with an increase in alcohol use or abuse” (Chafetz, 1998). The definitive review of research from around the world found that advertising has virtually no influence on consumption and has no impact whatsoever on either experimentation with alcohol or its abuse (Fisher, 1993, p.150). This is consistent with other reviews of the research. Advertising does not increase consumption. For example, alcohol brand advertising was first introduced in New Zealand in 1992. While advertising continues to increase, consumption continues to fall (www.beerwsc.co.nz/html/advertising-consumption.html). In this model, it shows that companies have direct “connection” with their target consumers through the employment of different advertising strategies, however, it does not necessarily follow that such promotional activity will subsequently increase or have a robust effect, influence and power over consumers’ purchasing behaviour and consumption. As firms conduct their marketing and promotional activities, there are intervening factors that exist and play vital roles as firms and the consuming public interact with each other. One is income. Despite a firm’s aggressive drive to market its product, despite rigid efforts to influence consumers’ preferences, income of an individual buyer will dictate him/her on whether to buy more of the product (if he/she has been buying the product) or switch to it. A consumer may desperately want to increase his usage of a commodity but if this consumer doesn’t have the capacity to buy more or to use the product more than he/she has already been consuming then this proves that advertising doesn’t really have too much bearing such buyer. Another intervening factor is gender. In the case of liquor or maybe beer products, sex of a consumer plays an essential factor in the determination of whether that product will be bought frequently or not. Although it has been noted that lots of women drink beer and liquor, still, as demanded by several cultures, women are not expected to buy or use too much of these commodities, not because they cant afford it but because it is expected of them to refrain from it if not totally stay away from it. Likewise, a major intervening factor is age. Certainly, minors have been strongly discouraged from alcohol. So, even if companies throw all their hats on enticing young people to drink and be “cool,” these kids will think twice before buying anything or before increasing their intake because, for one, they have to consider their young health – can they manage alcohol? Second, because they are young, they don’t possess the capacity to buy such commodities on a regular basis or increase their patronage because they just can’t. Employment and socio-economic status are closely tied up with income. If one is gainfully employed then of course the person has a source of income which subsequently means that the person has purchasing power but despite the existence of a job, it doesn’t guarantee anything. In the case of beer, certainly a person who has a job and who has the capacity to buy things wouldn’t think of buying beer before anything else or before the basic needs of his/her family have been met. PRINT SOURCES Dirken C.J. and Kroeger A. 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Congressional Record, May 20, 1985. Wilcox, G. B., Franke, G. R., and Vacker, B. Alcohol Beverage Advertising and Consumption in the United States: 1964-1984. Austin, TX: University of Texas, Department of Advertising Working Paper, January, 1986, p. III; Ogbourne, A. C., and Smart, R. G. Will restrictions on alcohol advertising reduce alcohol consumption? The British Journal of Addiction 75 (1980): 296-298 Chafetz, M. E. “Television Liquor Ads will not Promote Underage Drinking.” In: Scott, Barbour (ed.) Alcohol, Opposing Viewpoints. San Diego, CA: Greenhaven Press, 1998 Fisher, Joseph C. Advertising, Alcohol Consumption, and Abuse: A Worldwide Survey. Westport, CT: Greenwood Press, 1993 Nelson, Jon P. Broadcast Advertising and U. S. Demand for Alcoholic Beverages. University Park, PA: Pennsylvania State University, 1977 Read More