Consumer prices and advertising

There is a question in economic theory about the effects of advertising on the prices that consumers pay. Does advertising increase or decrease consumer prices? This debate, which goes back at least to Marshall (1919), is the subject of a new column at VoxEU.org.

The debate is between two effects of advertising. Some have argued that advertising increases the amount of competition in a market, and thereby reduces prices, by providing information to consumers, such as information on prices or the existence of products. But it has also been argued that advertising changes the preferences of consumers thereby shifting demand curves outwards, increasing the monopoly power of brands or decreasing elasticities of substitution. All such effects should lead to an increase in market prices. These different effects of advertising have been called, respectively, the ‘informative’ and ‘persuasive’ effect of advertising.

At VoxEU.org Ferdinand Rauch looks at Advertising and consumer prices. He writes,

In a recent study (Rauch 2011), I use a policy change in Austria to identify this price reaction for all industries. Austria is the only country in the OECD that charges a tax on advertising, which directly affects the cost of advertising. Before 2000, when a nationwide harmonisation introduced a 5% tax rate, each region had a different rate. Thus in 2000 the advertising tax, and therefore the cost of advertising, increased in parts of the country while simultaneously decreasing in other parts [...].

and continues,

I interpret this change of policy as a natural experiment, and collect data on prices of regional products to investigate its effects. I first show that the taxation of advertising is indeed a powerful instrument to restrict advertising expenditures of firms. I also show that advertising increased consumer prices in some industries such as alcohol, tobacco and transportation, in which the persuasive effect dominates. But it also decreased consumer prices in other industries such as food. I use data from existing marketing studies which make it possible to relate different responses of market prices to characteristics of advertisements in industries. I can indeed show that those industries which exhibit the informative price include more information in their advertisements, consistent with the interpretation of informational and persuasive forces of advertising.

The aggregate effect is informative, which means that, on average, advertising decreases consumer prices. This suggests that the Austrian advertising tax increases consumer prices and probably affects welfare adversely. I estimate that if the current 5% tax on advertising in Austria were abolished, consumer prices would decrease by about 0.25 percentage points on average.

So on average advertising seems to be more informative than persuasive. This does raise the question that if advertising is informative, why do it? If it increases competition and lower prices its seems, from the producer's point of view, a bad thing to do. Is it a prisoner's dilemma? If I advertise and my competition doesn't I do well and my competitors suffer but if my competitors advertise and I don't, I suffer and my competitors do well. But if one of us advertises and the other doesn't it is still better for both of us than having both of us not advertising. In such a world we both advertise and make both of us worse off.

References:

• Rauch, Ferdinand, ‘Advertising Expenditure and Consumer Prices’, CEP Discussion Paper 1073, 2011.
• Marshall, Alfred, Industry and Trade, Macmillan Publishing, 1919.