Price war or advertising collaboration?

One of the things I like about my textbook, is that it treats advertising as a separate influence on demand. In Dutch textbooks this is often raked up with other influences on taste. The author of my textbook even takes it one step further, by pointing out, in the chapter on price elasticity, that, in theory, you could calculate elasticity for anything that influences demand. So, I figured, this includes advertising. Therefore I did some research on advertising elasticity.

I found some MIT lectures notes1 on the topic, which I found rather interesting. In these lecture notes, the distinction between soft and hard competition is made. Firms compete hard, when they compete on price. They compete soft when they compete with advertising. The question was, how companies should compete. The answer is – it depends.

It depends on price elasticity and advertising elasticity.

The case put forward was the mass beer market. In the US there are three to four beer producers competing in the mass market, like Budweiser, Miller and Coors.2 As it turns out, there has been research on the price elasticity in the mass market for beer3, which was -0.8 when the lecture notes were written. Mind you, this is the price elasticity for the whole market. If all firms increased their price by 1% this would lead to a decline in demand of 0.8%.
However, the price elasticity for a particular brand can, in an oligopolistic market, be derived from it, if the dominating brands have about the same market share, as is the case in the US mass market for beer. To calculate an estimate of a brand’s price elasticity, you’d have to multiply the market price elasticity by the number of competitors, say three, so a US brand’s price elasticity is -0.8 x 3 = -2.4. A brand’s demand reacts much more elastic to price than the market demand.
This may look promising – decrease the price, and your brand’s demand will increase at the cost of your competitors. Surely your competitors would react to such an attack on their market share – a price war is on. This will lead to an erosion of profits, not something to look forward to. So let us look at the alternative.

The alternative would be an increase in advertising expenditure. According to the lecture notes, the elasticity of advertising for a typical brand of beer is quite low, somewhere between 0.1 and 0.2. Why is it this low? This is because advertising for brand A will not necessarily increase sales of brand A.
Imagen someone watching a brand A commercial during a sports event on television, and suddenly feels the need for a bottle of beer. He walks to the refrigerator and takes out ‘his’ brand B. Next time he goes to the store, he will replenish brand B, because that is what he habitually buys. So, advertising for brand A has increased sales for brand B. Brand A is in fact advertising for beer – in general.

This does not mean advertising expenditure was money wasted, because you know what else happens in markets with a relatively homogeneous product? Advertising helps buyers to differentiate between brands, and when buyers differentiate between brands4, they are willing to pay a higher price for their brand – across the whole mass market for beer. And since the market price elasticity in this market is inelastic, that is where the opportunity lies.

How can you use this in the classroom?

If your students were older than 18, I would suggest a blindfolded beer tasting5, but since that is not very likely, I would suggest the following questions:

  • Write down the formula for the advertising elasticity.6
  • Write down, in your own words, what an advertising elasticity of 0.15 means.7
  • With a brand’s price elasticity of -2.4, would revenue increase, decrease or stay the same when price increases? Why?8
  • In the short run, when brand A decreases its price from £ 2 to£ 1.80, with current demand 100,000 bottles, how much would its revenue increase?9
  • With a market price elasticity of -0.8, why do you think decreasing price may not be the best strategy for a beer producer?10
  • Ignoring the minus sign, would a brand’s price elasticity be higher, lower or the same as 2.4, if brands did not advertise?11

Other questions you might ask:

  • Should government impose a tax on alcoholic beverages, in order to reduce alcohol consumption, how much would that affect the mass market for beer?12
  • How much does advertising contribute to an allocation of resources within the doughnut13?14

  1. Lecture Notes on Market Definition, Concentration, and Optimal Advertising, Professor Robert S. Pindyck, Sloan School of Management, Massachusetts Institute of Technology, revised July 2015.
  2. One look in a Dutch supermarket reveals a similar number of competitors in the mass beer market, like Heineken, Amstel, Grolsch, Brand, and Jupiler beer. A look in an English supermarket shows a more differentiated market, with, I counted, about fifteen different lager brands.
  3. The outcome will depend on how you define the market, in this case the mass market for beer in the US, dominated by 3-4 brands.
  4. Although they may not taste the difference when blindfolded.
  5. This may make them less susceptible to the differentiating the beer producers are trying to do, so the next time they buy beer, they will buy the cheapest product – or go for a specialty beer instead.
  6. This could either be percentage change in quantity demanded divided by percentage change in advertising expenditure.
  7. An advertising elasticity of 0.15 means that a 1% increase in advertising expenditure will result in a 0.15% increase in demand. So, an advertising elasticity of 0.15 is inelastic.
  8. A price elasticity of -2.4 means that a 1% increase in price, will result in a decrease in sales by 2.4%. Since the decrease in sales is relatively larger than the increase in price, revenue will decrease. You can illustrate this with a numeric example:  Suppose price is £ 1 and sales is 100,000, so revenue is £ 100.000. A 1% increase in price means price will be £ 1.01, and sales will fall to 97,600, so revenue is 98,576, which is lower.
  9. Revenue is £ 2 x 100,000 =£ 200,000. A price decrease from £ 2 to £ 1.80, is a £ 0.20 lower price, which is 10% of £ 2. With a brand’s price elasticity of -2.4, sales will drop with 24%, which is a drop of 24,000. Therefore, after the price change, revenue will be £ 1.80 x 76,000 =£ 136,800, which is £ 63,200 lower.
  10. Since brand’s price elasticity is -2.4, a decrease in price will result in an increase in demand for brand A. But with a market price elasticity of -0.8, which is inelastic, total sales of beer will not go up much, therefore brand A will take market share from other beer producers. To protect their market share, they have to react by lowering the price too, which is destructive for all producers.
  11. Advertising causes buyers to differentiate between brands who are otherwise almost homogeneous. Should brands not advertise at all, it is likely buyers would not be able to differentiate, and it would be much easier to switch brands. Therefore the brand’s price elasticity is higher than 2.4, if brands did not advertise.
  12. Demand would decrease, but since the market price elasticity is inelastic, change in demand would be relatively lower than the change in price. This would mean a lower revenue for beer producers, since they do receive the price exclusive of tax. In the long run, buyers who think the price is now too high, in comparison to alternatives, might shift to alternatives, this would decrease demand even more.
  13. I am referring to the Doughnut Model of Kate Raworth.
  14. We have to ask two questions: should there be no advertising, would that change demand for beer much, and, does advertising contribute to a more equal distribution? To begin with the first question: the advertising elasticity of a typical brand is low, on average 0.15. So, advertising does not affect demand much. Should brands completely abandon advertising, this will not decrease demand much, and therefore not affect the allocation of resources much. Advertising does have an effect on distribution, since brand advertising causes buyers to differentiate between brands, thus increasing their willingness to pay a higher price. Therefore, more money is transferred from buyers to producers and advertising agencies, compared to a situation with no advertising and a lower price.