Advertising and consumer prices

Ferdinand Rauch 13 November 2012

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There is an old debate in economic theory, which goes back at least to Marshall (1919), about whether advertising increases or decreases the prices of consumer goods. Some have argued that advertising provides information to consumers, such as information on prices or the existence of products (for example Butters 1977 or Stahl 1989). This information increases the degree of competition in a market, and thereby lowers consumer prices. On the other hand, there is the view that advertising changes the preferences of consumers, for example by shifting demand curves outwards, increasing the monopoly power of brands or decreasing elasticities of substitution. All these effects should lead to an increase of market prices. These different effects of advertising have been called, respectively, the ‘informative’ and ‘persuasive’ effect of advertising.

The distinction is relevant for policymakers that consider taxing or banning advertising of certain goods, as a case could be made to tax primarily goods for which the persuasive effect dominates. On the other hand, informative advertising might be welfare increasing, and some models even suggest that a subsidy for informational advertising would increase welfare.

Existing empirical evidence has demonstrated that prices of various goods react to changes in advertising costs differently. For example, advertising seems to decrease prices for eyeglasses (Kwoka 1984), children’s breakfast cereals (Clark 2007) and drugs (Cady 1976), while it increases the supply price in brewing industries (Gallet and Euzent 2002).

In a recent study (Rauch 2011), I use a policy change in Austria to identify this price reaction for all industries. Austria is the only country in the OECD that charges a tax on advertising, which directly affects the cost of advertising. Before 2000, when a nationwide harmonisation introduced a 5% tax rate, each region had a different rate. Thus in 2000 the advertising tax, and therefore the cost of advertising, increased in parts of the country while simultaneously decreasing in other parts, as highlighted in Figure 1.

Figure 1. Change in advertising costs

I interpret this change of policy as a natural experiment, and collect data on prices of regional products to investigate its effects. I first show that the taxation of advertising is indeed a powerful instrument to restrict advertising expenditures of firms. I also show that advertising increased consumer prices in some industries such as alcohol, tobacco and transportation, in which the persuasive effect dominates. But it also decreased consumer prices in other industries such as food. I use data from existing marketing studies which make it possible to relate different responses of market prices to characteristics of advertisements in industries. I can indeed show that those industries which exhibit the informative price include more information in their advertisements, consistent with the interpretation of informational and persuasive forces of advertising.

The aggregate effect is informative, which means that, on average, advertising decreases consumer prices. This suggests that the Austrian advertising tax increases consumer prices and probably affects welfare adversely. I estimate that if the current 5% tax on advertising in Austria were abolished, consumer prices would decrease by about 0.25 percentage points on average.

References

Butters, Gerard, ‘Equilibrium Distributions of Sales and Advertising Prices’, The Review of Economic Studies, Vol 44, 465-510, 1977.

Cady, John, ‘An estimate of the price effects of restrictions on drug price advertising’, Economic Enquiry, Vol 14(4), 493-510, 1976.

Clark, Robert, ‘Advertising Restrictions and Competition in the Children’s Breakfast Cereal Industry’, The Journal of Law and Economics, Vol 50, 2007.

Gallet, C and P Euzent, ‘The Business Cycle and Competition in the US Brewing Industry’, Journal of Applied Business Research, Vol 18, 2002.

Kwoka, John, ‘Adverting and the price and quality of optometric service’, The American Economic Review, Vol 74(1), 1984.

Marshall, Alfred, Industry and Trade, Macmillan Publishing, Stadt ist wichtiger als Verlag 1919.

Rauch, Ferdinand, ‘Advertising Expenditure and Consumer Prices’, CEP Discussion Paper 1073, 2011.

Stahl, Dale O, Oligopolistic Pricing with Sequential Consumer Search, The American Economic Review, Vol 79, No 4, 1989.

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Topics:  Microeconomic regulation Taxation

Tags:  tax, consumer prices, advertising

Lecturer at the Department of Economics, University of Oxford, and CEPR.