# Principles of Microeconomics, v. 2.0

by Libby Rittenberg and Timothy Tregarthen

## 11.3 Extensions of Imperfect Competition: Advertising and Price Discrimination

### Learning Objectives

1. Discuss the possible effects of advertising on competition, price, and output.
2. Define price discrimination, list the conditions that make it possible, and explain the relationship between the price charged and price elasticity of demand.

The models of monopoly and of imperfectly competitive markets allow us to explain two commonly observed features of many markets: advertising and price discrimination. Firms in markets that are not perfectly competitive try to influence the positions of the demand curves they face, and hence profits, through advertising. Profits may also be enhanced by charging different customers different prices. In this section we will discuss these aspects of the behavior of firms in markets that are not perfectly competitive.

Firms in monopoly, monopolistic competition, and oligopoly use advertising when they expect it to increase their profits. We see the results of these expenditures in a daily barrage of advertising on television, radio, newspapers, magazines, billboards, passing buses, park benches, the mail, home telephones, and the ubiquitous pop-up advertisements on our computers—in virtually every medium imaginable. Is all this advertising good for the economy?

We have already seen that a perfectly competitive economy with fully defined and easily transferable property rights will achieve an efficient allocation of resources. There is no role for advertising in such an economy, because everyone knows that firms in each industry produce identical products. Furthermore, buyers already have complete information about the alternatives available to them in the market.

But perfect competition contrasts sharply with imperfect competition. Imperfect competition can lead to a price greater than marginal cost and thus generate an inefficient allocation of resources. Firms in an imperfectly competitive market may advertise heavily. Does advertising cause inefficiency, or is it part of the solution? Does advertising insulate imperfectly competitive firms from competition and allow them to raise their prices even higher, or does it encourage greater competition and push prices down?

There are two ways in which advertising could lead to higher prices for consumers. First, the advertising itself is costly; it amounts to hundreds of billions of dollars annually in the United States. By pushing up production costs, advertising may push up prices. If the advertising serves no socially useful purpose, these costs represent a waste of resources in the economy. Second, firms may be able to use advertising to manipulate demand and create barriers to entry. If a few firms in a particular market have developed intense brand loyalty, it may be difficult for new firms to enter—the advertising creates a kind of barrier to entry. By maintaining barriers to entry, firms may be able to sustain high prices.

But advertising has its defenders. They argue that advertising provides consumers with useful information and encourages price competition. Without advertising, these defenders argue, it would be impossible for new firms to enter an industry. Advertising, they say, promotes competition, lowers prices, and encourages a greater range of choice for consumers.

Advertising, like all other economic phenomena, has benefits as well as costs. To assess those benefits and costs, let us examine the impact of advertising on the economy.

Advertising does inform us about products and their prices. Even critics of advertising generally agree that when advertising advises consumers about the availability of new products, or when it provides price information, it serves a useful function. But much of the information provided by advertising appears to be of limited value. Hearing that “Pepsi is the right one, baby” or “Tide gets your clothes whiter than white” may not be among the most edifying lessons consumers could learn.

Some economists argue, however, that even advertising that seems to tell us nothing may provide useful information. They note that a consumer is unlikely to make a repeat purchase of a product that turns out to be a dud. Advertising an inferior product is likely to have little payoff; people who do try it are not likely to try it again. It is not likely a firm could profit by going to great expense to launch a product that produced only unhappy consumers. Thus, if a product is heavily advertised, its producer is likely to be confident that many consumers will be satisfied with it and make repeat purchases. If this is the case, then the fact that the product is advertised, regardless of the content of that advertising, signals consumers that at least its producer is confident that the product will satisfy them.

If advertising creates consumer loyalty to a particular brand, then that loyalty may serve as a barrier to entry to other firms. Some brands of household products, such as laundry detergents, are so well established they may make it difficult for other firms to enter the market.

In general, there is a positive relationship between the degree of concentration of market power and the fraction of total costs devoted to advertising. This relationship, critics argue, is a causal one; the high expenditures on advertising are the cause of the concentration. To the extent that advertising increases industry concentration, it is likely to result in higher prices to consumers and lower levels of output. The higher prices associated with advertising are not simply the result of passing on the cost of the advertising itself to consumers; higher prices also derive from the monopoly power the advertising creates.

But advertising may encourage competition as well. By providing information to consumers about prices, for example, it may encourage price competition. Suppose a firm in a world of no advertising wants to increase its sales. One way to do that is to lower price. But without advertising, it is extremely difficult to inform potential customers of this new policy. The likely result is that there would be little response, and the price experiment would probably fail. Price competition would thus be discouraged in a world without advertising.

Empirical studies of markets in which advertising is not allowed have confirmed that advertising encourages price competition. One of the most famous studies of the effects of advertising looked at pricing for prescription eyeglasses. In the early 1970s, about half the states in the United States banned advertising by firms making prescription eyeglasses; the other half allowed it. A comparison of prices in the two groups of states by economist Lee Benham showed that the cost of prescription eyeglasses was far lower in states that allowed advertising than in states that banned it.Lee Benham, “The Effect of Advertising on the Price of Eyeglasses,” Journal of Law and Economics 15(2) (1972): 337–352. Mr. Benham’s research proved quite influential—virtually all states have since revoked their bans on such advertising. Similarly, a study of the cigarette industry revealed that before the 1970 ban on radio and television advertising market shares of the leading cigarette manufacturers had been declining, while after the ban market shares and profit margins increased.Woodrow Eckard, “Competition and the Cigarette TV Advertising Ban,” Economic Inquiry 29(1) (January 1991), 119–133.

Advertising may also allow more entry by new firms. When Kia, a South Korean automobile manufacturer, entered the U.S. low-cost compact car market in 1994, it flooded the airwaves with advertising. Suppose such advertising had not been possible. Could Kia have entered the market in the United States? It seems highly unlikely that any new product could be launched without advertising. The absence of advertising would thus be a barrier to entry that would increase the degree of monopoly power in the economy. A greater degree of monopoly power would, over time, translate into higher prices and reduced output.

Advertising is thus a two-edged sword. On the one hand, the existence of established and heavily advertised rivals may make it difficult for a new firm to enter a market. On the other hand, entry into most industries would be virtually impossible without advertising.

Economists do not agree on whether advertising helps or hurts competition in particular markets, but one general observation can safely be made—a world with advertising is more competitive than a world without advertising would be. The important policy question is more limited—and more difficult to answer: Would a world with less advertising be more competitive than a world with more?

## Price Discrimination

Throughout the text up to this point, we have assumed that firms sold all units of output at the same price. In some cases, however, firms can charge different prices to different consumers. If such an opportunity exists, the firm can increase profits further.

When a firm charges different prices for the same good or service to different consumers, even though there is no difference in the cost to the firm of supplying these consumers, the firm is engaging in price discriminationSituation in which a firm charges different prices for the same good or service to different consumers, even though there is no difference in the cost to the firm of supplying these consumers.. Except for a few situations of price discrimination that have been declared illegal, such as manufacturers selling their goods to distributors at different prices when there are no differences in cost, price discrimination is generally legal.

The potential for price discrimination exists in all market structures except perfect competition. As long as a firm faces a downward-sloping demand curve and thus has some degree of monopoly power, it may be able to engage in price discrimination. But monopoly power alone is not enough to allow a firm to price discriminate. Monopoly power is one of three conditions that must be met:

1. A Price-Setting Firm The firm must have some degree of monopoly power—it must be a price setter. A price-taking firm can only take the market price as given—it is not in a position to make price choices of any kind. Thus, firms in perfectly competitive markets will not engage in price discrimination. Firms in monopoly, monopolistically competitive, or oligopolistic markets may engage in price discrimination.
2. Distinguishable Customers The market must be capable of being fairly easily segmented—separated so that customers with different elasticities of demand can be identified and treated differently.
3. Prevention of Resale The various market segments must be isolated in some way from one another to prevent customers who are offered a lower price from selling to customers who are charged a higher price. If consumers can easily resell a product, then discrimination is unlikely to be successful. Resale may be particularly difficult for certain services, such as dental checkups.

Examples of price discrimination abound. Senior citizens and students are often offered discount fares on city buses. Children receive discount prices for movie theater tickets and entrance fees at zoos and theme parks. Faculty and staff at colleges and universities might receive discounts at the campus bookstore. Airlines give discount prices to customers who are willing to stay over a Saturday night. Physicians might charge wealthy patients more than poor ones. People who save coupons are able to get discounts on many items. In all these cases a firm charges different prices to different customers for what is essentially the same product.

Not every instance of firms charging different prices to different customers constitutes price discrimination. Differences in prices may reflect different costs associated with providing the product. One buyer might require special billing practices, another might require delivery on a particular day of the week, and yet another might require special packaging. Price differentials based on differences in production costs are not examples of price discrimination.

Why would a firm charge different prices to different consumers? The answer can be found in the marginal decision rule and in the relationship between marginal revenue and elasticity.

### Answers to Try It! Problems

1. Senior citizens are (usually!) easy to identify, and for travel, preventing resale is usually quite easy as well. For example, a picture ID is required to board an airplane. Airlines might be expected to oppose implementing the rule since it is costly for them. The fact that they support the rule can be explained by how it aids them in practicing price discrimination, by preventing the resale of discount tickets, which now can easily be matched to the purchasing customers. The demand for air travel by senior citizens is likely to be more elastic than it is for other passengers, especially business travelers, since the purpose of their travel is largely discretionary (often touristic in nature) and since their time is likely to be less costly, making them more willing to seek out information on travel alternatives than the rest of the population.
2. Since the customer must present the coupon at the point of sale, identification is easy. Willingness to search for and cut out coupons suggests a high degree of price consciousness and thus a greater price elasticity of demand.
3. Such students are likely to have more choices of where to attend college. As we learned in an earlier chapter on elasticity, demand is likely to be more elastic when substitutes are available for it. Enrollment procedures make identification and prevention of resale very easy.