Mostly summarized from Gregory Mankiw’s Principles of Economics, 5^th Ed.

PART 5 Firm Behavior and the Organization of Industry

Chapter 16 of 36 Monopolistic Competition  

Section 11 of 15

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Every day we are surrounded by advertising, firms trying to convince us to buy their products.

This is natural for monopolistic competition as well as some oligopolistic industries.

When firms sell differentiated products and charge prices above marginal cost each firm has an incentive to advertise to attract more buyers to its product.

Firms that sell highly differentiated consumer goods such as medical drugs, perfumes, soft drinks, razor blades, breakfast cereals typically spend between 10 and 20 percent of revenue for advertising.

Firms that sell industrial products such as drill presses and communications satellites typically spend very little on advertising.

Firms that sell homogeneous products, such as wheat, peanuts, or crude oil, rarely spend any amount.

About two percent of total business revenue is spent on advertising.

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Is society wasting resources on advertising, or does advertising serve a valuable purpose?

Critics of advertising contend advertisements create a desire that otherwise might not exist.

They say firms largely advertise to affect people's tastes, much advertising is psychological rather than informational.

Consider a television commercial for a brand of soft drink.

The commercial likely does not tell the viewer about the product's price or quality.

Instead, it might show a group of happy people at a party on a beach, holding cans of the soft drink.

The commercial’s goal is to create a subconscious message: you too can have many friends and be happy if you drink our product.

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Critics also argue advertising impedes competition, saying advertising often tries to convince consumers products are more different than they actually are.

By increasing the perception of product differentiation and fostering brand loyalty, advertising makes buyers less concerned with price differences among similar goods.

By creating a less elastic demand curve, less sensitivity to price, firms can charge a larger markup over marginal cost.

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Defenders of advertising argue firms use advertising largely to provide information to customers.

Advertising conveys prices of the products, advantages of the products, existence of new products, and locations of retail outlets.

This information allows customers to make better choices about what to buy, enhancing the ability of markets to allocate resources efficiently.

Defenders also argue advertising fosters competition, saying advertising allows customers to be more fully informed about all the firms and products in the market.

Customers can more easily know and take advantage of price differences.

Each firm has less market power, less control over prices.

Advertising allows new firms to enter more easily, helping entrants to attract customers away from existing firms

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Policymakers have mostly accepted the view advertising makes markets more competitive.

One example is the regulation of advertising for some professions such as lawyers and doctors.

In the past groups in these markets persuaded state governments to prohibit advertising in their fields because advertising was "unprofessional."

In recent years courts have mostly concluded the primary effect of these restrictions on advertising was to limit competition.

In recent years states have largely eliminated the laws that previously prohibited advertising in these markets.