Advertising

The Definition of Advertising in Economics

Why do think there is no advertising for tomatoes on TV but countless ads for frozen pizzas? Is it because tomato producers do not want to increase sales, but the frozen pizza producers love money? I wouldn’t say so. The advertisement costs money, and it is worth the expense only if the firms have some market power over their products and can differentiate themselves from the other brands in one way or another.

In this case, it is more likely to differentiate the frozen pizzas since pizza producers can use different ingredients, have different prices, or offer products for customers with specific allergies, such as gluten. However, there are not a lot of ways to differentiate the products in the tomato market.

In a perfectly competitive market, where marginal revenue equals marginal cost, the firms would have no incentives to spend money on advertisement since they can not charge more for their products. However, in monopolistic competition, many firms are actively offering products that are similar but not perfect substitutes to each other. Thus, firms in monopolistic competition have some market power over their products. Their market power allows them to act as price setters rather than price takers, as we also see in a monopoly. This is important for monopolistic competitive firms as they earn zero economic profit in the long run.

Economic Benefits of Advertising

Firms try to convince potential customers to buy more of a certain product at a given price level through advertisements. Sounds alright, but why do the advertisements work?

Economic Effects of Advertising

First of all, advertisement is an efficient way for firms to inform the customers about their products. They can explain the best qualifications of the products, how they are better than their competitive products or announce new products in the market. By doing so, they increase the sales of existing products or accelerate the adoption of new ones. In this fast-changing competitive world, firms need to use advertisements to raise brand awareness, strengthen brand loyalty and find creative and efficient ways to reach their target customers groups and, if possible, take possible market shares from their competitors' brands.

Although it is very costly to put an advertisement on TV or billboards, or even on Instagram ads, the firms can have a significant level of return on investment (ROI), meaning they will earn multiple dollars for each dollar they put on advertisement.

Fig. 1 - Pepsi Cola Billboard

Economic Rationale to Create Advertising

As we see, firms use different advertisement channels to increase their growth through informing the customers, increasing brand loyalty, and alerting them about the deals or changes. How are we, as consumers, influenced by the different advertisement strategies?

Figure 1. Attracting Customers, StudySmarter Original

When it is hard to have complete information about the products, advertisements could be good indicators. Think about shopping on eBay, why do the bold and large ads displays attract us the most? They are more likely to catch the customers’ eyes first, for sure. Since more customers click on it, the number of reviews is also higher. This might signal to us that the product is in high demand and which indirectly signals that it is of high quality or the seller is reliable. After all, the seller can afford to pay for a larger display.

What about the firms using celebrities in the advertisements? Watching a celebrity presenting a cereal in an advertisement means that the cereal brand is better than others? Does it show us that the celebrity has a perfect taste that is pretty similar to ours and we will like it one hundred percent if the celebrity suggests it?

Maybe, consumers are not as rational in our decision-making process as the economists assume. This might hold certainly for some of the customers. Even for rational customers, it might be still true that watching a celebrity eating a specific cereal in an advertisement affects their judgments or even preferences. But how?

The answer lies in the signals of the advertisements of the brands. If you see a celebrity eating a specific cereal on TV, it means that the brand is powerful enough to pay the high cost that is necessary to hire a celebrity. This means that the firm is large and cares for its products, which also signals if you are not happy with one of the products and want to re-fund for instance, you would probably find support since such large firms have developed customer services.

For breakfast cereal, customer service might not be so important but what about more valuable purchases, for instance, a laptop? You would prefer to buy a well-known brand rather than a local brand that you have never heard of, right? Why is that? Probably, you would feel more safe buying a laptop from a well-known brand since you assume they would be there if you have some trouble after the purchase. Even though there is no reason why the local brand would not be reliable, you would go for the brand you know, the one you feel familiar with yourself.

In this example, the only aspect that affects your judgments is the degree of how familiar are you with the brand. And what makes a brand more well-known? Well, nothing but lots of advertisements… As we see here, the raised brand awareness through advertisements matters a lot for sales.

Brand Names

What about the relationship between advertisements and brand names? By differentiating the products and communicating this through advertisements, a firm can create a brand perception where customers might connect the brand name with characteristics or even values. By doing so, firms can create and increase their brand loyalty. If customers perceive a product better in particular ways compared to alternatives, customers are usually more likely to have a higher willingness to pay.

Reliability is one of the mains aspects that customers look for while shopping. This is the underlying strategy of most successful brands, they raise good brand awareness and keep it by providing good service and efficient advertisement strategies.

Examples of advertising and brand names

Commercial chains can be a good example of the reliability of brands. Let’s say you are out of town and have a coffee break at a service area. There are two options to buy a coffee: Starbucks and a local coffee shop. Which shop would you prefer? If customers are there for the first time, all else being equal, they usually go to the shop that they know. Like the shop, they know they can easily picture the various products available which are more appealing than the mystery of an unknown coffee shop.

This is even more likely if they have previous good experience in Starbucks or even more if there is some kind of loyalty programs like a Starbucks card or App. This choice generally has nothing to do with the taste or quality of the coffee since the customers have not tried the local shop before. In this case, the brand name of Starbucks signals reliability, good service guarantee, and less risk, which may be worth far more than the coffee itself.

Why the chain brand is less risky? If you have a bad coffee there, you would complain about it later and this affects your next purchase from Starbucks. You would not only go to this particular shop again but also not buy from any Starbucks even again, which is a very undesirable outcome for the brand.

This gives Starbucks an incentive to keep and protect the same standards in all their shops worldwide associated with the brand name. However, if you decide to go to the local shop and have a bad experience, it may not matter a lot to them because it is very unlikely that you would go to that service area again anyway.

As we see in the Starbucks example, brand names work as an assurance of the offered products due to the repeated interaction with customers. Thus, the brand names convey some information and signal a high level of reliability.

Fig. 3 - Starbucks shop

Advantages and Disadvantages of Advertising

There are multiple advantages of advertising products for both customers and the firm. Customers can be informed about the new products and have some kind of assurance of the service or product thanks to the brand name and repeated interaction aspect we discussed above. Similarly, firms use the advertisement as a channel to build brand awareness, reach their target groups and increase sales eventually.

However, there may be some disadvantages of advertising. One major aspect is that the big brands often have great market powers that they can control the price levels. Since we do not have perfect competition in real life, there are significant barriers for new firms to enter the market. Even though the local shop in the above example has a great coffee and service, it has a disadvantage compared to chains like Starbucks. Since the local shop's budget is likely not so large to have advertisements to the general public like TV or billboards, the gap between the well-known brands and the local brands might grow even more. This may lead us to less competitive markets in the long run.

Another aspect is related to the effect of the fame of the brand on the decision-making process of customers. Consumers often pay higher prices for brand-name goods even though they can purchase products with similar qualifications or quality at cheaper store brands.

Think about the luxury watch brand Rollex and its waiting list. As we know, for a certain level of demand, decreasing the supply would increase the equilibrium price. Since they limit the production quantity, they can sell the same product for a higher price and people are waiting their turn to be able to purchase the product. Is it because Rollex watches have the greatest quality and no other watch is that good? Probably, the brand name plays a greater role than the quality here.

One way or another, the brand names and advertisements are pretty effective on purchasing behavior. Maybe, you do not find them attractive on TV at all, but they probably catch your attention which contributes to the brand image on your mind. And next time you are shopping in the market, you purchase the products of this brand without being aware of it. Maybe this does not work every single time or for everyone, but it sure affects the majority in the long term.