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 13 of 15

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An advertisement might have a famous actor eating a cereal and saying how great it tastes.

Does the advertisement provide information?

Defenders of advertising argue even advertising that appears to contain little hard information may actually tell consumers something about product quality.

The willingness of a firm to spend money on advertising can itself signal to consumers about the product quality.

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Imagine Post and Kellogg have just created recipes for a new cereal, selling price for both to be $3 a box.

Each company’s research shows if it spends $10 million on advertising one million consumers will try its new cereal.

If consumers like the cereal, they will buy it many times.

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Post knows its new cereal is neither high quality nor distinctive.

Although advertising would induce sales of a box to one million consumers to try it the consumers would quickly learn the cereal is not very good and will not buy it again.

Post acknowledges the likely loss and decides not to advertise and sell the cereal.

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Kellogg is confident its cereal will sell repeatedly after people try it.

It estimates each person who tries it will buy a box a month for the next year.

The $10 million in advertising will create $36 million in sales

This advertising is profitable because Kellogg has a quality product consumers will buy repeatedly.

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It is rational for consumers to try new products they see advertised.

Consumers decide to try Kellogg's new cereal because of their advertisements.

Kellogg signals to consumers the quality of its cereal by its willingness to spend money on advertising.

Consumers think, "if Kellogg is willing to spend so much money advertising this new cereal, it must be very good."

Kellogg signals the quality of its product by its willingness to spend money on advertising.

What the advertisement says is not as important as the fact consumers know ads are expensive.

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Cheap advertising is not effective at signaling quality to consumers.

Suppose if an advertising campaign costs less than e.g. $3 million, both Post and Kellogg would decide to use advertisements to market their new cereals.

Because both good and mediocre cereals would be advertised consumers could not infer the quality of a new cereal from the fact it is advertised.

Eventually consumers would ignore such cheap advertising

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This helps explain why firms pay famous actors big money to make advertisements that appear to convey no information at all.

The information about quality is not in the advertisement content but in its expense.