‘Advertising’ involves the dissemination of information about an organisation, product, service, or idea through the mass media (eg television, radio, newspapers, magazines, billboards etc) by a particular sponsor (the advertiser).
A key feature of advertising is that the advertiser does not communicate directly with the customer. Rather, the advertiser communicates via the mass media. Typically, this means that:
the information is provided not only to potential consumers of the product, but also other sections of the community that may have no interest in the product; and
there is no opportunity for immediate feedback from the consumer.
This distinguishes advertising from ‘direct marketing’ which involves greater targeting of potential consumers, and approaching those potential consumers directly to generate an expression of interest or a sale. This provides an opportunity for suppliers to obtain direct feedback from individual consumers on the nature of their preferences. Direct marketing is discussed further in Chapter 4.
The demand for advertising originates from consumer demand for accurate information on goods and services.
As discussed in Chapter 2, in order to make informed decisions, consumers need to know not only their own preferences, but also the prices, performance, and availability of all goods and services they might want to consume. In reality, however, it is simply too costly for consumers to seek to:
acquire all of the information they would require to make fully rational decisions. This is discussed further in sections 3.2.2 and 3.2.3. The existence of this ‘bounded rationality’ provides advertisers with the scope to engage in ‘persuasive’ advertising to influence consumer preferences, or even deceive consumers); and
determine the prices, performance, and availability of all goods and services they may want to consume.
The information provided by advertising has the potential to reduce all of these costs to a significant extent. It can assist consumers to clarify their preferences, identify the prices and availability of products that can potentially satisfy those preferences, and help consumers evaluate the performance of those products and determine when they should replace those products with new, improved versions.
A key feature of advertising is that it is not normally purchased separately by the consumer. Rather, it is an information service that is provided by the firm at the expense of consumers of the firm’s products. When consumers decide to purchase a product, they are also in effect deciding to purchase the advertising information that has been supplied by the firm to promote that product. The cost of the product includes a portion of the cost of funding the advertising that was used to promote the firm’s products.
Similarly, when an individual chooses to consume the information provided by the media (eg free to air TV, radio broadcast, newspapers, or magazines) they are also in effect deciding to consume the advertising information disseminated by that media. The revenue raised by selling advertising space is in effect used to subsidise the cost of supplying the other information disseminated in the media.
As a result, demand for the advertising of a particular firm is determined by the combined demand for the firm’s product and the advertising itself.
Since there are costs to consumers associated with the assimilation of information, they tend to be willing to pay more for that information when it is supplied in an enjoyable form. As a result, there is a degree of complementarity in demand for information and demand for entertainment. This helps explain the presence of both ‘entertaining’ advertising and the packaging of advertising with entertaining programs.
Advertising is of course not the only potential source of information on product price, performance and availability.
Another important source of such information is the consumer’s own consumption experience. Indeed, the quality and performance of certain goods and services can really only be determined after they have been purchased and used.
The costs of such experimentation can vary considerably over different types of goods and services. For example, the costs of experimentation tend to be higher for products that are either essential to the consumer’s health and wellbeing, or comprise a high proportion of their budget. These include financial services such as life and home insurance and health related products such as pharmaceutical products. For such products, the financial and non-pecuniary costs to the consumer from an inappropriate product choice are very high. By contrast, the costs of experimentation tend to be much lower for lower cost products that are ‘discretionary’ purchases.
Individual consumers can reduce their costs of experimentation by relying on information provided by other consumers, or surveys of other consumers’ views, or other more aggregate signals of consumer views of product quality such as:
brand names and company reputation (ie consumers tend to equate more popular brand names and more reputable firms with higher quality products); and
the price of the product (ie consumers tend to equate higher product prices with higher product quality).
3.2.2 Supply of advertising
The magnitude of the potential costs that consumers face when trying to identify the price, performance and availability of the goods and services they wish to consume has important implications for firms.
In particular, it provides firms with a significant incentive to supply consumers with ‘informative’ advertising aimed at outlining the types, prices and performance of the goods and services those firms are able to supply. Firms, particularly new firms, or firms selling new and improved products, cannot simply sit back and expect consumers to locate them.
In view of the ‘bounded rationality’ of consumers, however, firms also have the incentive and ability to engage in ‘persuasive’ advertising which is aimed at influencing the preferences of consumers for products. Such ‘persuasive’ advertising can take a number of forms. For example, it can range from advertisements that are intended to help consumers to clarify their preferences, through to advertisements intended to mislead or deceive the consumer as to the price or performance of the product. In an effort to gain public attention, there is also a risk that persuasive advertising can be presented in a form that certain sections of the community find offensive. The external costs that such misleading, deceptive, and offensive advertising impose on consumers and society are discussed further in section 3.2.3.
Advertising is used extensively by virtually all types of firms in Australia ranging from small retailers through to large multinational firms.
Advertising is most prevalent in product markets where there are large numbers of firms supplying differentiated products (ie in markets characterised by ‘monopolistic’ competition and ‘heterogenous’ products). In such markets, firms tend to engage in non-price forms of competition such as advertising, packaging, product branding, and the development of firm reputation. The reluctance of such firms to engage in price competition in these markets is related to the tendency of consumers, in the presence of uncertainty, to use product price as a signal of product quality. Rather than increase sales, a reduction in price has the potential to reduce sales by signalling to consumers that the product is of lower quality.
Advertising is of course not the only means that firms have available for promoting their products. Rather, it is only one of several methods that firms can use to promote and market their products. Other important promotional tools include direct marketing and direct selling, sales promotion, publicity and public relations. Over the last decade, there has been an increasing trend among companies to implement systems of ‘integrated marketing communications’ that seek to co-ordinate all of the promotional and marketing methods that influence community perceptions of the firm’s reputation and its product brands.
3.2.3 Nature of market failure(s)
As discussed in Chapter 2, one of the major reasons why markets, such as the market for advertising, fail to operate efficiently is the presence of asymmetric information between firms and consumers.
In particular, firms have access to much more accurate information on the price, performance and availability of their products than consumers. This provides firms with an opportunity to increase their sales through the provision of ‘informative’ advertising.
At the same time, however, it also provides scope for firms to engage in misleading and deceptive advertising. That is, firms have the option of either reducing existing information asymmetries through the provision of ‘informative’ advertising, or by using ‘persuasive’ advertising to create new, or to exacerbate existing information asymmetries. Advertising, like other forms of information, has the character of an ‘experience’ good. That is, it is difficult to judge the quality of information provided simply by looking at it. Rather, it is typically necessary to ‘consume’ that information prior to being able to determine its accuracy.
By contrast, firms have much less accurate information about the preferences of their consumers for particular types of products and advertising campaigns. Unlike direct marketing, advertising does not provide a firm with a direct means of obtaining feedback from a consumer on their preferences other than via the price mechanism. That is, the most direct and immediate feedback that advertisers receive on consumer preferences in relation to their products and advertising campaigns is via their sales figures.
Advertisers can of course gain some idea of the preferences of their consumers through less direct and immediate methods such as consumer surveys and the nature of the complaints they receive either directly, or via the Advertising Standards Bureau. The procedures followed by the ASB when processing complaints are outlined in section 3.3.6.
Although advertising can be an important source of information that works to improve the overall efficiency of product markets, it has also been criticised for the external costs it imposes on consumers and the wider community. These external costs include the costs of providing misleading and offensive advertising.
The ability of advertisers to engage in misleading advertising is limited to some extent by a number of factors including:
Other sources of information available to consumers. As noted above, advertising is not the only source of product information available to consumers. Consumers can also obtain product information from other consumers, consumer organisations, and their own consumption experience. The existence of these other sources of information limits the extent to which advertisers can mislead consumers.
Potential damage to an advertiser’s reputation. Advertisers, particularly those making repeat sales of products to consumers, incur significant amounts of expenditure to develop their reputations as reliable suppliers.
Competition between advertisers. Each advertiser has an incentive to refute the deceptive advertising claims of their competitors.
The potential for legal action by consumers.
However, the incentive and ability of consumers, and other advertisers, to detect and take action against misleading advertising is also limited by a number of factors including:
The nature of the advertising. A sufficiently ‘inventive’ advertisement can mislead consumers while making it extremely difficult for those consumers and advertisers that are adversely affected to prove in a court of law that they have been mislead.
The delays associated with non-price competition.
The ‘bounded rationality’ of consumers.
The reluctance of consumers to admit they have been deceived (ie the existence of ‘cognitive dissonance’).
Advertising can also produce external benefits for some sections of the community. For example, consumers who base their decisions heavily on advertising by a firm in effect have their costs of acquiring that information subsidised by other consumers of the product whose decisions were not heavily influenced by that advertising. These spillovers arise due to the practical difficulties and costs associated with determining the values that consumers attach to the advertising of the product as opposed to the product itself, and charging consumers for those differences.
Consumers of ‘free to air’ television and radio broadcasts, newspapers and magazines that are funded by advertising revenue also have the potential to reap external benefits from the advertising expenditure of firms. In general, the magnitude of those external benefits will be greater:
the lesser the extent to which that advertising detracts from their enjoyment of the television or radio broadcast, or the other information provided in the newspaper or magazine; and
the lower their expenditure on the advertised goods and services (ie the smaller the contribution they make to funding the cost of that advertising).
The advertising expenditure of one firm can also produce benefits that spill over onto other firms. For example, it can result in a consumer deciding to purchase the product of another firm that is either producing a substitutable or a complementary product. Where two firms produce complementary products, there may be scope for internalising those external benefits by jointly funding advertising campaigns that promote both the product and its complement (eg combined advertising of washing machines and recommended brands of washing powder).
Public good nature of advertising
Advertising, like all forms of information, also exhibits the features of a public good, and this tends to reduce the efficiency with which the market for advertising operates.
That is, it is often difficult to exclude individuals who have not paid for advertising expenditure from enjoying the benefits of that advertising (non-excludability), and the consumption of advertising by one individual does not diminish the potential benefits available to other consumers of advertising (‘jointness’ or ‘non-rivalry’ in consumption).
Market failure due to imperfect competition
The supply of advertising typically involves three main entities:
the advertiser, who funds the advertising;
the in-house or external advertising agency that develops the advertising campaign; and
the media operators who disseminate the advertising.
In most product markets, there are large numbers of highly competitive advertisers. However, the overall efficiency with which the advertising market operates can be reduced by the presence of imperfect competition in some product markets and the major media markets, as well as the significant economies of scale in advertising.
Advertising is both a potential source of increased competition between firms supplying heterogeneous products, and a potential means for firms to artificially differentiate their products in order to reduce competition.
The existence of advertising is itself an indication of the lack of perfect competition. In the presence of perfect competition, an individual firm does not have an incentive to advertise. Although a successful advertising campaign would increase demand for the output of the industry, it would be of very little benefit to the individual firm that advertised. In effect, the benefits produced by that advertising would be spread over the large number of small firms in the industry. That is, the advertising by one firm would produce an external benefit for all firms. Advertising would only be profitable if all of the firms in the industry banded together to engage in a joint advertising campaign.
In view of the pervasive nature of advertising, and its potential not only to misinform, but to actually alter individual’s preferences, advertising has been the subject of a great deal of controversy and criticism. In particular, persuasive advertising has been criticised on the grounds that it:
exploits certain groups of the community, particularly children, the old and the infirmed, who have less experience and/or sound knowledge in order to evaluate products, or to critically analyse the persuasive nature of an advertising campaign;
perpetuates social stereotypes, particularly in relation to women; and
encourages materialism (ie it suggests that the acquisition of goods and services leads to happiness, suggests that material possessions are symbols of social status and will lead to greater social acceptance, popularity).