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LECTURE 3: ADVERTISING ELASTICIES. AEM 4550: Economics of Advertising Prof. Jura Liaukonyte. Plan of the Lecture. Other Elasticities Advertising Elasticity Measures of Market Concentration Relationship between Advertising and Market structure: Dorfman-Steiner Condition

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lecture 3 advertising elasticies

LECTURE 3:ADVERTISING ELASTICIES

AEM 4550:Economics of AdvertisingProf. Jura Liaukonyte

plan of the lecture
Plan of the Lecture
  • Other Elasticities
  • Advertising Elasticity
  • Measures of Market Concentration
  • Relationship between Advertising and Market structure:
    • Dorfman-Steiner Condition
    • Optimal Advertising levels
    • Advertising to sales ratios across different industries
    • Product differentiation and Advertising
other demand elasticities
Other Demand Elasticities
  • Income Elasticity of Demand
    • Measures how much quantity demanded changes with a change in income
values for income elasticity e i
Values for Income Elasticity (EI)
  • Sign indicates normal or inferior

 EI>0 implies normal good.

EI<0 implies inferior good.

  • Normal goods may be necessity or luxury.
other demand elasticities5
Cross-Price Elasticity of Demand

Measures the percentage change in the quantity demanded of one good that results from a one percent change in the price of another good

Other Demand Elasticities
other demand elasticities6
Other Demand Elasticities
  • Complements: Cars and Tires
    • Cross-price elasticity of demand is negative
      • Price of cars increases, quantity demanded of tires decreases
  • Substitutes: Butter and Margarine
    • Cross-price elasticity of demand is positive
      • Price of butter increases, quantity of margarine demanded increases
example the cross price elasticity of demand for cars
Example: The Cross-Price Elasticity of Demand for Cars
  • Source: Berry, Levinsohn and Pakes, "Automobile Price in Market Equilibrium," Econometrica 63 (July 1995), 841-890.
magnitude shows size of shift in demand assume p subst increases
Magnitude shows size of shift in Demand (assume Psubst increases)

EXY>1

PX

PX

D’

D’

D

D

QX

QX

EXY<1

price elasticity of supply
Price Elasticity of Supply
  • Measures the sensitivity of quantity supplied given a change in price
    • Measures the percentage change in quantity supplied resulting from a 1 percent change in price
mr mc
MR = MC
  • Profit is p(q) = TR(q) - TC(q)
  • Profit maximization: dp/dq = 0
  • This implies dTR(q)/dq - dTC(q)/dq = 0
  • But dTR(q)/dq = marginal revenue
  • dTC(q)/dq = marginal cost
  • So profit maximization implies MR = MC
monopoly cont
Monopoly (cont.)
  • Derivation of the monopolist’s marginal revenue

$/unit

Demand

MR

Demand: P = A - B.Q

Total Revenue: TR = P.Q = A.Q - B.Q2

Marginal Revenue: MR = dTR/dQ

MR = A - 2B.Q

With linear demand the marginal

revenue curve is also linear with the same price intercept

but twice the slope of the demand curve

Quantity

lerner index
Lerner Index
  • Lerner Index
  • L = (p - MC)/p = 1/|EP|
  • The higher the number, the more pricing power the firm has.
  • Mark-up power reflects monopoly power.
  • PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark-up will increase.
advertising elasticity
Advertising Elasticity
  • Measures the sensitivity of demand given a change in advertising
advertising elasticity14
Advertising Elasticity
  • Ad-inelastic demand curve: Demand does not shift much from advertising.
    • Example: concrete: Consumers’ purchasing decisions are mostly based on price and related terms of sale.
  • Ad-elastic demand curve: Demand is relatively responsive to advertising.
    • Example: soda: Consumers’ purchasing decisions can be easily swayed by effective advertising campaigns.
advertising elasticity15
Advertising Elasticity
  • Two key results from advertising
    • The marginal gain from advertising expenditures is greater the more sensitive the demand curve is to advertising expenditures.
    • Firms should advertise more when the demand curve is more sensitive to advertising expenditures.
market concentration
Market Concentration
  • Industries have very different structures
    • Numbers and size distributions of firms
      • Ready-to-eat breakfast cereals: high concentration
      • Newspapers: low concentration
  • How best to measure market structure
    • Concentration ratio
    • Herfindahl-Hirschman Index (HHI)
    • Lerner Index (LI)
  • Let’s look at each of them:
industry concentration
Industry Concentration
  • Four-Firm Concentration Ratio
    • The sum of the market shares of the top four firms in the defined industry. Letting Si denote sales for firm i and ST denote total industry sales
  • Herfindahl-Hirschman Index (HHI)
    • The sum of the squared market shares of firms in a given industry, multiplied by 10,000: HHI = 10,000 S wi2, where wi = Si/ST.
measure of concentration
Measure of concentration
  • Compare two different measures of concentration:

Firm Rank Market Share Squared Market

(%) Share

1 25

625

2 25

625

3 25

625

4 5

25

5 5

25

6 5

25

7 5

25

8 5

25

Concentration Index

measure of concentration19
Measure of concentration
  • Compare two different measures of concentration:

Firm Rank Market Share Squared Market

(%) Share

1 25

25

625

2 25

25

625

3 25

25

625

4 5

5

25

5 5

25

6 5

25

7 5

25

8 5

25

H = 2,000

Concentration Index

CR4 = 80

concentration index is affected by e g merger
Concentration index is affected by, e.g. merger

Firm Rank Market Share Squared Market

(%) Share

1 25

25

Market shares

change

625

Assume that firms

4 and 5 decide

to merge

2 25

25

625

3 25

25

625

4 5

5

}

}

}

25

5 5

25

6 5

25

7 5

25

8 5

25

Concentration Index

CR4 = 80

H = 2,000

concentration index is affected by e g merger21
Concentration index is affected by, e.g. merger

Firm Rank Market Share Squared Market

(%) Share

1 25

25

Market shares

change

625

Assume that firms

4 and 5 decide

to merge

2 25

25

625

3 25

25

625

4 5

5

}

}

}

25

100

10

5 5

25

6 5

25

7 5

25

8 5

25

Concentration Index

CR4 = 80

H = 2,000

concentration index is affected by e g merger22
Concentration index is affected by, e.g. merger

Firm Rank Market Share Squared Market

(%) Share

1 25

25

625

2 25

25

625

3 25

25

625

4 5

5

}

}

}

25

100

10

5 5

25

6 5

The Concentration

Index changes

25

7 5

25

8 5

25

Concentration Index

CR4 = 80

85

H = 2,000

2,050

slide23
HHI
  • The Herfindahl-Hirschman Index – the square of the percentage market share of each firm summed over the largest 50 firms in the industry (or all of the firms if there is less than 50)
    • In perfect competition, the HHI is small
    • In monopoly, the HHI is 10,000 (100 squared)
    • A popular measure with the Justice Dept in the 1980’s
  • HHI < 1000 characterized competitive markets
  • HHI > 1800 would bring Justice Dept challenge to proposed mergers
  • e.g. The cigarette industry is highly concentrated with only 8 firms and a Herfindahl-Hirschman Index (HH1) of 2623
example
Example:

Candy and Chocolate Industry

candy v chocolate
Candy v. Chocolate

CANDY

HHI (for top 4) = 1141

CR ₄ = 59%

Medium level concentration

->Concentration is increasing!

1,039 businesses overall!!

CHOCOLATE

HHI (for top 4)= 2941.81

Cr ₄ = 78.1%

High level of concentration

518 Businesses overall!!

cr and hhi candy industry
CR₄ and HHI: Candy Industry
  • The HHI for just the top 4 companies in the industry is 2941.81.
  • The CR ₄ for the industry is 78.1%.
  • Therefore, the industry is highly concentrated with only a few major firms holding a majority of the market share.

HHI = 49.5²+21.6²+4²+3²=2941.81

CR ₄ = 49.5 + 21.6 + 4 + 3= 78.1%

*Hershey and Mars Inc. alone hold 71.1% of the market share.

-Many mergers occur.

example27
Example

Credit Card Industry

market definition
Market Definition
  • All Credit Lending Institutions with their own card
    • 27.2% J.P. Morgan Chase & Co.
    • 19.2% Bank of America Corporation
    • 18.9% Citigroup Inc.
    • 17.2% American Express Company
    • 4.0% Capital One
  • CR4: 83.2
  • HHI: 1810-1850
  • Total Number of Companies: 192
what is a market
What is a market?
  • No clear consensus
    • The market for automobiles
      • Should we include light trucks; pick-ups SUVs?
    • The market for soft drinks
      • What are the competitors for Coca Cola and Pepsi?
    • With whom do McDonalds and Burger King compete?
  • Presumably define a market by closeness in substitutability of the commodities involved
    • How close is close?
    • How homogeneous do commodities have to be?
fast food outlets
Fast-Food Outlets

McDonald’s

Burger King

Wendy’s

market performance
Market Performance
  • Market structure is often a guide to market performance
  • But this is not a perfect measure
    • Can have near competitive prices even with “few” firms
  • Measure market performance using the Lerner Index

P-MC

LI =

P

lerner index32
Lerner Index
  • L = (p - MC)/p = 1/|EP|
  • Lerner Index is bound between (0,1)
  • Closer to 1 the more pricing power the firm has.
  • Mark-up power reflects monopoly power.
  • PUNCHLINE: If elasticity increases, mark-up will decline. If the product becomes less elastic, mark-up will increase.