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Advertising and Competition

17 April, 2015 - 12:23

If advertising creates consumer loyalty to a particular brand, then that loyalty may serve as a barrier to entry to other firms. Some brands of household products, such as laundry detergents, are so well established they may make it difficult for other firms to enter the market.

In general, there is a positive relationship between the degree of concentration of market power and the fraction of total costs devoted to advertising. This relationship, critics argue, is a causal one; the high expenditures on advertising are the cause of the concentration. To the extent that advertising increases industry concentration, it is likely to result in higher prices to consumers and lower levels of output. The higher prices associated with advertising are not simply the result of passing on the cost of the advertising itself to consumers; higher prices also derive from the monopoly power the advertising creates.

But advertising may encourage competition as well. By providing information to consumers about prices, for example, it may encourage price competition. Suppose a firm in a world of no advertising wants to increase its sales. One way to do that is to lower price. But without advertising, it is extremely difficult to inform potential customers of this new policy. The likely result is that there would be little response, and the price experiment would probably fail. Price competition would thus be discouraged in a world without advertising.

Empirical studies of markets in which advertising is not allowed have confirmed that advertising encourages price competition. One of the most famous studies of the effects of advertising looked at pricing for prescription eyeglasses. In the early 1970s, about half the states in the United States banned advertising by firms making prescription eyeglasses; the other half allowed it. A comparison of prices in the two groups of states by economist Lee Benham showed that the cost of prescription eyeglasses was far lower in states that allowed advertising than in states that banned it. 1 Mr. Benham’s research proved quite influential—virtually all states have since revoked their bans on such advertising. Similarly, a study of the cigarette industry revealed that before the 1970 ban on radio and television advertising market shares of the leading cigarette manufacturers had been declining, while after the ban market shares and profit margins increased. 2

Advertising may also allow more entry by new firms. When Kia, a South Korean automobile manufacturer, entered the U.S. low-cost compact car market in 1994, it flooded the airwaves with advertising. Suppose such advertising had not been possible. Could Kia have entered the market in the United States? It seems highly unlikely that any new product could be launched without advertising. The absence of advertising would thus be a barrier to entry that would increase the degree of monopoly power in the economy. A greater degree of monopoly power would, over time, translate into higher prices and reduced output.

Advertising is thus a two-edged sword. On the one hand, the existence of established and heavily advertised rivals may make it difficult for a new firm to enter a market. On the other hand, entry into most industries would be virtually impossible without advertising.

Economists do not agree on whether advertising helps or hurts competition in particular markets, but one general observation can safely be made—a world with advertising is more competitive than a world without advertising would be. The important policy question is more limited—and more difficult to answer: Would a world with less advertising be more competitive than a world with more?