Chocolate and Gold Coins

Tuesday, June 14, 2005

Are We Paying Too Much for Advertising?

“It pays to advertise” but are we paying too much for it? Half Sigma has been exploring this issue in this post and in this post. Here is an excerpt:

In our marketing based economy, we usually have oligopolies selling goods which the sellers have tried very hard to present as non-fungible. Depending on the price elasticity of demand for the items in question, firms may find it more beneficial to compete on the non-price components of marketing. These marketing expenses are then passed on to consumers.

To use the toothpaste example, this might mean that it’s easier to sell a $2.50 tube of toothpaste than it is to sell a $1.25 tube of toothpaste. Imagine you were able to manufacture toothpaste and well it at a wholesale price point such that it could sell for $1.25 retail, half the price of other brands. Do you think you would sell any? Would the supermarkets be jumping at the opportunity to sell your budget toothpaste? Most likely not. You would have to spend huge amounts of money on marketing in order to convince consumers to buy it and supermarkets to stock it, and the end result would be that your marketing costs were so high that you now have to sell it for the same price as all the other toothpastes.

I think that Half Sigma has part of the story here. Advertising signals quality: low quality products compete on price and eschew advertising. There is a famous example of the Piels Brother Brewery ads that were extremely popular in the 1950’s. The brewery eventually went out of business. Legend has it that the ads brought so many new first-time customers to an inferior product that it created a huge amount of bad word-of-mouth. Eventually, the few people who used to buy the product because it was cheap and they couldn’t tell the difference between a quality beer and an inferior beer were too ashamed to buy the beer anymore. I don’t buy that storyline completely but I agree that it doesn’t pay to advertise an inferior product.

We learn that high-quality producers advertise more than low-quality producers. Since advertising costs money and quality production cost money we would expect that the well-advertised product would cost more and would be better quality than other products. If people don’t shop around and at least occasionally sample other products, there is the possibility that two identical products could sell for very different prices in the market place.

This is not just a possibility, it happens. Many manufactures of name-brand items will secretly sell the very same product as a generic item. Why do they do that? Because the advertising is a huge cost of the product, and if marginal cost of production is low, they might as well cut in on the generic market. Of course, they risk being their own competition. But they know most people don’t shop around and will never know that a generic product is just as good as the more expensive name-brand.

So the possibility exists that for many products you are paying extra only for the advertising and not for what is actually inside the box. But this can happen only for low-priced items. If manufacturers spend too much on advertising, people will try the no-name brands, and find one that is reasonably good.

The point I’m making is that shoppers do have to be savvy in the marketplace. You may well be paying too much for your toothpaste and your shampoo because you assume the well-advertised product is the best product. However, if everyone believes that, then we may be overlooking some quality products that are choosing to compete on price instead of on advertising.


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