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Endogeneity and Simultaneity in Competitive Pricing and Advertising: A Logit Demand
Analysis
Author(s): Pradeep K. Chintagunta, Vrinda Kadiyali and Naufel J. Vilcassim
Source: The Journal of Business , Vol. 79, No. 6 (November 2006), pp. 2761-2787
Published by: The University of Chicago Press
Stable URL: https://www.jstor.org/stable/10.1086/507998
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Pradeep K. Chintagunta
University of Chicago
Vrinda Kadiyali
Cornell University
Naufel J. Vilcassim
London Business School
Endogeneity and Simultaneity in

Competitive Pricing and Advertising:
A Logit Demand Analysis*
I. Introduction In this article, we use

four data sets to provide
The logit model is widely used by marketing research- a benchmark study of the
ers. At the household level, starting with the study by effects of accounting for
Guadagni and Little (1983), it has been used exten- endogeneity and simulta-
neity in estimating mar-
sively to study the affect of marketing variables on keting-mix effects in a
household brand-choice behavior. The logit specifi- logit demand framework.
cation has also been used to model the relationship We compare the results
between the aggregate market shares and the market- obtained from accounting
ing activities of the various brands in the given product for endogeneity only to
those from accounting for
market (Allenby 1989). Some recent studies have both endogeneity and si-
shown that, under certain conditions, the substantive multaneity, and in the lat-
implications for the effects of marketing variables are ter case we allow for
similar whether one uses the model at either the ag- more general models of
gregate (e.g., store/chain) or the disaggregate (i.e., firm behavior to examine
the consequences of im-
household) level (Allenby and Rossi 1991; Gupta et posing assumptions about
al. 1996). the behavior of firms. We
A methodological issue in estimating the effects of find that accounting for
marketing activities on brand market shares using the both endogeneity and si-
multaneity not only af-
fects the parameter esti-
* We thank Sanjay Dhar and Sachin Gupta for their generosity
with their time and data and Inseong Song for data-extraction help.
mates but also results in
We also thank the editor and an anonymous reviewer for their efficiency gains that af-
comments on the article. Contact the corresponding author, Pradeep fect the statistical signifi-
K. Chintagunta, at [email protected]. cance of the estimates.
(Journal of Business, 2006, vol. 79, no. 6)

䉷 2006 by The University of Chicago. All rights reserved.
0021-9398/2006/7906-0001$10.00
2761

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2762 Journal of Business
logit model is that of endogeneity of firm choices (see Besanko, Gupta, and
Jain [1998] and Sudhir [2001a] using aggregate data and Villas-Boas and
Winer [1999] using household data). The general issue of endogeneity of firm
choices has been recognized in marketing (Chintagunta and Vilcassim 1992;
Erickson 1992; Kadiyali, Vilcassim, and Chintagunta 1996; Shanker 1997;
Cotterill, Putsis, and Dhar 2000). However, researchers using the logit model
have only recently recognized that estimating the response parameters while
ignoring the decision rules that govern firms’ actions could lead to biased and
inconsistent estimates of these parameters.
The importance of the endogeneity issue is based on the following argument.
Firms in the marketplace make decisions on their marketing-mix variables
every time period. An important input into these decisions is the nature of
the response of the firm’s market share to these marketing activities, that is,
the marketing response function. For that, the logit model has been empirically
found to provide a good representation. From the perspective of researchers
trying to uncover the “true” effects of the marketing variables, however, it
creates the following econometric problem. The researcher observes only a
subset of variables, such as price and advertising, that drive firms’ market
shares. Other variables, such as distribution and market coverage, which are
not observed (but are known to firms), are treated as being part of the “error”
term in the model. If firms’ choices of price and advertising levels depend
on those (unobserved) variables, for example, price depends on product at-
tributes, the explanatory variables in the model are correlated with the error
term, which results in the endogeneity problem.
In the context of the logit model, the above econometric problem has been
addressed in one of two ways. The first approach is to focus only on the
demand side and use instruments for price and advertising. These instruments,
while being correlated with the marketing-mix variables, are treated as being
uncorrelated with the error term. For example, in his study of the ready-to-
eat cereal market across several geographic regions, Nevo (2001) uses the
levels of marketing activities in geographic region Y (for example) as instru-
ments for these variables in region X.
The alternative approach to address the endogeneity issue is to explicitly
postulate the behavioral mechanism by which firms set their prices and ad-
vertising levels and use this information in estimating the demand parameters.
This method, therefore, not only accounts for the endogeneity of the price
and advertising variables but also accounts for the simultaneity of the quantity,
price, and advertising decisions (see, e.g., Berry 1994; Berry, Levinsohn, and
Pakes 1995; Besanko et al. 1998). Hence, the main difference between the
two methods is that the former focuses only on the demand function to obtain
consistent estimates for the effects of marketing-mix variables, whereas the
latter uses additional information regarding the “supply side.” The latter ap-
proach is, thus, an equilibrium demand-and-“supply” model.
In using the latter approach mentioned above, the question that arises is,
How do firms make price and advertising choices that compose the “supply

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Competitive Pricing and Advertising 2763
side”? Typically, a firm is assumed to maximize some objective function, for

example, its profit level. If it is further assumed that all firms behave in a
similar fashion, then the observed market behavior vis-à-vis price and ad-
vertising (for example) are the “equilibrium” outcomes for these firms. This
gives us two sets of equations: (1) the logit response functions that link the
firms’ market shares to their marketing activities via a set of response param-
eters and (2) a set of decision rules, based on optimizing behavior of firms
that link the marketing activities of the firm to its market shares via the same
set of model parameters. Together, they compose a simultaneous demand and
supply-side system. Econometrically, therefore, the approach of using only
the demand function with instrumental variables accounts for the endogeneity
of firms’ actions, whereas the latter approach accounts for endogeneity as well
as for simultaneity in the response function and firms’ decision rules (for an
early study on the importance of accounting for simultaneity, see Bass [1969]).
Clearly, including the equilibrium conditions involves a trade-off. On the
one hand, it can provide insights into the supply side (and the firms’ cost
functions). On the other hand, it imposes more demands on the data, and an
incorrect specification of the firms’ marketing-mix decisions could lead to
biased parameter estimates. Researchers have not hitherto addressed this issue
and compared the estimates for price and advertising effects obtained from
the two approaches.
An especially interesting aspect of misspecification of firms’ marketing-
mix decisions is the role of competition in these decisions. Most previous
articles that have accounted for the supply side in pricing decisions, for ex-
ample, Berry (1994), Berry et al. (1995), and Besanko et al. (1998), have
imposed a very specific form of competition among firms. They assume that
firms in the market interact with one another in a Bertrand-Nash fashion. The
actual form of competition in the market may be different from this assump-
tion. This implies that the associated pricing-decision rule can be very different
from that associated with Bertrand-Nash. Imposing a Bertrand-Nash supply
formulation, therefore, amounts to misspecification of the supply side, which
can lead to inconsistent demand parameter estimates as well.
When advertising decisions are considered, we face an additional com-
plexity in accounting for this source of misspecification on the supply side.
It is likely that advertising decisions have multiperiod effects on the demand
side. This results in a dynamic, as opposed to a static or single-period, analysis
of firm behavior. While one can continue to assume that firms make decisions
every period, these decisions will now have to account for the effects of
current advertising on future firm profits. In addition, a supply-side model of
advertising must also accommodate competitive interactions in a flexible man-
ner so as to obtain unbiased estimates of the demand parameters, as well as
the cost or supply-side parameters.
When obtaining price and advertising levels for dynamic problems, two
kinds of equilibrium have typically been studied—open loop and closed loop
(see Erickson 1992). Deriving open-loop equilibrium for our model formu-

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lation is relatively straightforward. In a recent study, Vilcassim, Kadiyali, and

Chintagunta (1999) also examined price and advertising competition in a
dynamic context. In that study, while the authors did incorporate flexible forms
of market interaction, the analysis was not done using a logit demand model,
and the advertising dynamics were incorporated using a limited 2-period model
formulation. A more complete analysis requires that the firm’s decision prob-
lem be formulated as one of infinite horizon. Deriving closed-loop equilibrium
advertising strategies while accommodating flexible forms of market conduct
has remained elusive, despite advances in the theoretical literature on dynamic
games (Maskin and Tirole 1988).
Consequently, we propose an intermediate solution that we refer to as an
“adaptive policy.” Adaptive decisions, like closed-loop decisions, take into
consideration rivals’ future-period reactions to the firm’s actions in the current
period. The key difference between adaptive and closed-loop policies is that
the latter can be parameterized entirely by the firms’ demand and cost pa-
rameters. In our proposed adaptive policy, by contrast, firms’ reactions need
to be explicitly parameterized via additional dynamic conduct parameters
(DCPs) that capture rivals’ future actions. When the DCPs are zero, the adap-
tive policy reverts to the open-loop solution. By allowing these DCPs to take
any value, we allow for a general competitive model. This helps get around
the potential misspecification problem with using the open-loop solution. Be-
cause open-loop price and advertising levels are obtained without accounting
for such intertemporal reactions, we refer to them as “nonadaptive policies.”
Therefore, for product markets where firms make price and advertising
decisions, we estimate two versions of the supply-side equilibrium—the dy-
namic nonadaptive policy and the dynamic adaptive policy. Further, the non-
adaptive decisions are nested within the adaptive behavior, and this allows us
to empirically determine which model of firm behavior is most consistent
with the data.
Summarizing, in this article we pursue the issue of endogeneity in the logit
demand model. We compare three approaches used to account for endoge-
neity—the first accounts for demand-side endogeneity, the second accounts
for supply side as well but with restricted competitive assumptions, and the
third accounts for a more general competitive model. The empirical analysis
is done for a variety of market conditions. These are
1. for three product categories (yogurt, a hair-care product, and coffee);
2. at different levels of market aggregation—national for the hair-care
product, national and regional for coffee, and a local market for yogurt;
3. with weekly (yogurt and hair-care product) as well as monthly (coffee)
data; and
4. for two different marketing-mix decisions (price for yogurt; price and
advertising for the other two).
The main contributions of this research are as follows. On the theoretical
side, we extend the current literature on accounting for price endogeneity and

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simultaneity to the advertising domain. In particular, we obtain approximate

closed-form optimization rules for advertising when the carryover effects of
this marketing instrument are accounted for. The more important contribution,
however, is in showing empirically that ignoring the problem of endogeneity
and simultaneity leads to biases in the estimated effects of price (and adver-
tising) on demand. Interestingly, with a general formulation of interactions
among firms, the Hausman test fails to reject the hypothesis that the set of
parameters obtained when only accounting for endogeneity is significantly
different from the specification that accounts for both endogeneity and si-
multaneity. Further, we show that imposing a restricted competitive assumption
on the supply side produces inaccurate estimates on the demand side (and
supply side). This finding is robust across four data sets and, hence, provides
a benchmark for comparative purposes.
The remainder of this article is organized as follows. In Section II, we
provide the model formulation. This is followed by a description of the em-
pirical specification in Section III. In Sections IV and V, we discuss the data
and empirical results. The final section concludes.
II. Model Formulation

Our objective in this section is to derive the dynamic equilibrium pricing and
advertising rules that compose the supply side, given that an aggregate logit
model can specify demand. These rules will be used in the analysis to account
for the simultaneity of competitive price and advertising. We derive first the
equilibrium advertising and pricing for the nonadaptive case, which is then
followed by the adaptive case.
The market share of brand i, Sit (i p 1, 2, … , N) in period t is given by the
logit model1
exp (a i ⫹ bpit ⫹ gCA it ⫹ drit )
Sit p
冘 N
jp1 exp (aj ⫹ bpjt ⫹ gCA jt ⫹ drjt )
, (1)
where ai is the intrinsic preference for brand i, pit is the price of brand i in
period t, b is price sensitivity, g is advertising sensitivity, rit is the nonprice
promotional intensity of brand i in period t, d is promotional sensitivity, N is
the number of competing brands in the market, and CAit denotes the cumulative
advertising effect from all previous periods and the current period for brand
i. In other words, if Ait represents the current period advertising for brand i
(measured in gross rating points [GRPs]), then
CA it p A it ⫹ 冘
t⫺1
tp0
j t⫺tA it , (2)
1. By including a 1 in the denominator of the logit expression, we can also allow for the
brands in the market to influence overall category sales. The 1 reflects the “outside good.”

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where j is the carryover of advertising GRPs from one period to the next.
Note that the existence of the carryover creates an intertemporal linkage in
demand for the N firms (brands).
The advertising investments are measured in GRPs. Consequently, we need
to translate these into monetary terms for use in the profit function. We define
the advertising cost function (ACF), which relates GRPs to dollars, at time t
by the following expression:
ACFit p v1i A it ⫹ v2i A it2 , (3)
where v1i and v2i are parameters that translate GRPs into dollars. Depending
upon the magnitudes and signs of the parameters, v1i and v2i, advertising costs
can be linear, concave, or convex in GRPs. Rather than impose a specific
functional relationship between GRPs and dollar costs, we propose to estimate
these parameters from market data.
We assume that firms choose their price and advertising levels in each time
period. Given advertising carryover, in each period t the firm chooses its price
and advertising level that maximizes profits from that period on. Hence, the
firm’s profit-maximization problem becomes one of infinite horizon and is
equal to
写冘[
⬁
max
pit, Ait
i
p
tpt
]
(pit ⫺ c i )MSit ⫺ v1i A it ⫺ v2i A it2 rt⫺t , (4)
where M is the (fixed) market size, rt is the discount factor associated with
profits t periods hence, and r 0 p 1. The assumption of a fixed market size
is not an issue if the share formulation for Sit in equation (1) includes an
outside good (see n. 1). However, in the absence of the outside good, one
needs to check whether M depends on the prices and advertising levels of the
N brands. Note from equation (4) that the firm’s control variables are the price
and advertising levels in each period. As noted previously, there are two
solution concepts (nonadaptive and adaptive) that can be used to obtain the
equilibrium price and advertising levels. We discuss these in turn.
Open-Loop (Nonadaptive) Solution

The necessary conditions for a nonadaptive equilibrium are obtained by setting
⭸P i ⭸P i
p p 0. (5)
⭸pit ⭸A it
Assuming that there are no price dynamics and that pit affects profits only in
period t, deriving the price first-order condition is straightforward and yields
1
pit p c i ⫺
b(1 ⫺ Sit ⫺ 冘j(i mjiPPSjt )
, (6)
where the parameters mjip p are introduced to capture deviations from Bertrand-

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Nash (which we refer to simply as “Nash”) equilibrium pricing.2 We refer to

them as “conduct parameters” (CPs), and they allow for flexible forms of
interaction among firms. If all the CPs are zero, then the interaction among
firms is Nash. Otherwise, competition among firms will be “softer” or “stron-
ger” than Nash pricing, depending on the sign of the CPs. Hence, these CPs
reflect the contemporaneous interactions among firms that can result in de-
viations from Nash behavior.
The nonadaptive (i.e., open loop) advertising level is obtained by differ-
entiating the right-hand side of equation (4) with respect to Ait. Note that
because Ait appears in each of the terms in the objective function, one has to
explicitly take this into account in the differentiation. Doing so, we obtain
the nonadaptive-advertising policy as follows:
i ( pit ⫺ c i) Sit 1 ⫺ Sit ⫺

A it p Mg ( 冘
j(i
mjiAASjt ⫺ v1i
)
⫹ Mg
i 冘⬁
tp1
rtj t ( pi,t⫹t ⫺ c i) Si,t⫹t 1 ⫺ Si,t⫹t ⫺
( 冘
j(i
)
mjiAASj,t⫹t . (7)
In the above expression, Mi p M/(2v2i ), and v1i p v1i /(2v2i ). There are several
aspects about equation (7) worth noting. First, the right-hand side of the
equation is a function only of observable prices and shares and the model
parameters. It is not a function of cumulative advertising levels. Further, if
j p 0, then the equation reduces to that from a static optimization problem.
Note, however, that the above expression entails an infinite sum. In empirical
situations, one will not have access to the entire future time paths for the
firms. The actual number of terms to be included in the above expression will
depend on the discount factors for the firms. If firms do not weigh profits
beyond a certain number of time periods, then the weight for the subsequent
profits can be set to zero. Consequently, these terms would drop out of the
equation. Second, the mjiAA parameters are the advertising CPs and, as in the
case of price, capture deviations from Nash behavior. Whether advertising
competition is “stronger” or “softer” than Nash will depend on the signs and
magnitudes of the CPs (if they are all zero, we will have Nash competition).
As described previously, the nonadaptive nature of the equilibrium derives
from firm i not explicitly incorporating rivals’ responses in period t ⫹ 1 to
its pricing and advertising levels in period t. The adaptive equilibrium we
discuss next explicitly accounts for such behavior.
Adaptive Solution (or General Form of Competition)

A firm’s profit-maximization problem, as set up above, cannot be solved for
closed-loop policies. We explored Markov-perfect equilibria as in Maskin and
Tirole (1988). This again revealed no solutions for the problem at hand. The
economics literature has seen recent advances using numerical methods to
2. The conduct parameter mjimm p ⭸mjt /⭸mit for marketing instrument m, brands j and i.

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characterize Markov-perfect equilibria (Pakes 1998). However, these methods

do not apply to our problem because the dynamic element in those models
(investing in the improving “quality”—the brand-specific intercepts) is such
that it does not create an intertemporal link in the demand or cost functions
over time. Consequently, the profits for the firms’ at any given point in time
are functionally independent of the firms’ actions in the previous time periods.
This is not the case with our model formulated because of the advertising
carryover effects. Hence, we cannot use the methods based on Markov-perfect
equilibria to address the problem at hand.3
The key difference between the nonadaptive and adaptive solution is that
the latter explicitly takes into account a rival’s reactions to the firm’s actions.
The most general case occurs when
i) a firm can react to a rival’s action at time t in time period t and in
any future time period, and
ii) a firm can react with the same instrument or a different instrument
than that used by the rival firm.
Under i and ii, the necessary conditions for an adaptive equilibrium are given
by
⭸P i
⫹
⬁
冘 冘 (
 N ⭸P i
⭸pit tp1 jp1 ⭸pj,t⫹t
#
⭸pj,t⫹t
⭸pit
⫹
⭸P i
⭸Aj,t⫹t
#
⭸Aj,t⫹t 
⭸pit
p 0; )
 j(i 
冘 冘 (
⬁
⭸P i  N ⭸P i ⭸Aj,t⫹t ⭸P i ⭸pj,t⫹t 
⫹
⭸A it tp1 jp1 ⭸Aj,t⫹t
#
⭸A it
⫹
⭸pj,t⫹t
#
⭸A it
p 0. )
 j(i 
In the above equations, the terms ⭸pj /⭸pi, ⭸Aj /⭸A i, ⭸pj /⭸A i, and ⭸Aj /⭸pi
capture the reactions for the different firms at different time periods and
different instruments. These intertemporal reactions are referred to as the
DCPs. Because reactions in price could differ from reactions in advertising,
firms have separate price and advertising DCPs. In principle, one can obtain
a closed-form solution to the above equations. However, empirical imple-
mentation is infeasible because there are infinitely many DCPs in the above
equation. Hence, we focus on a very specific form of reaction.
We assume that the intertemporal reactions are Markovian in nature. In
other words, firm j reacts to firm i’s decisions in period t, but it does so in
period t ⫹ 1. Similarly, a reaction in period t ⫹ 2 is a consequence of actions
in period t ⫹ 1, and so forth. Just as is the case with Markov-perfect equilibria,
it is important to note that this is only one among several possible strategies
that firms can follow. Nevertheless, it is an appealing strategy because of its
3. The general dynamic programming problem is given by Bellman’s equation as follows:

Vt(CAt) p suppit,Ait [(pit ⫺ cit)MSit ⫺ v1i Ait ⫺ v2i Ait2 ⫹ Vt⫹1(CAt⫹1)]. It is easy to verify that there is
no closed-form solution to the above problem.

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“payoff relevant” property. We also assume that reactions take place in the
initiating marketing instrument only. Hence, reactions to price changes with
changes in advertising (and vice versa) are not considered. There is some
empirical support for this assumption. For example, Leeflang and Wittink
(1992) find that although cross-instrument reactions do occur, simple reactions
are far more common. The assumption also helps us conserve degrees of
freedom in data. Operationally, as we show below, DCPs measure the devi-
ations of a firm’s price and advertising levels from the nonadaptive case.
Hence, when these DCPs p 0, the firm behaves according to the nonadaptive
equilibrium described previously.
We note that in a recent study, Erickson (1997) also examined dynamic
advertising decisions using a conjectural variations framework. There are,
however, some important differences between Erickson’s and our approach.
The most important difference is that we estimate some of the dynamic con-
duct, or dynamic conjectural variation, parameters directly from the data,
whereas Erickson sets them to some chosen values. As stated previously, the
adaptive policy we develop has as a special case the open-loop equilibrium,
and it might well be that in a given empirical situation, the open-loop solution
may be the one most consistent with the data. Clearly, it is preferable to “let
the data speak,” rather than impose nonzero values for the dynamic conjectural
variation parameters. This also helps reduce the possibility of incorrect demand
parameter estimates arising from misspecification of the supply function. Ad-
ditionally, Erickson uses a Lanchester model for the evolution of market
shares, whereas our objective is to examine the endogeneity within the context
of a logit demand model where more than a single marketing-mix variable
has to be analyzed.
The necessary conditions for an adaptive equilibrium, are therefore given
by
⭸P i
冘
⭸P i ⭸pj,t⫹1
N
⫹ # p 0;
⭸pit jp1 ⭸pj,t⫹1 ⭸pit
j(i
⭸P i
冘 ⭸P i ⭸Aj,t⫹1
N
⫹ # p 0. (8)
⭸A it jp1 ⭸Aj,t⫹1 ⭸A it
j(i
The key difference between the necessary conditions in equations (6)–(8)

is the presence of the DCP terms. These terms denote the response by firm
j in period t ⫹ 1 to firm i’s actions in time period t that are accounted for by
firm i while making its price and advertising decisions. In the following, we
denote the DCPs as follows:
⭸ pj,t⫹1 ⭸ Aj,t⫹1
mjiD p p p ; mjiDAA p . (9)
⭸ pit ⭸ A it

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The D in the above DCPs refers to “dynamic.” As before, deriving the

price first-order condition for the adaptive equilibrium is straightforward and
is given by
 冘 S (1 ⫺ S ⫺ 冘
1  N Si,t⫹1 Sj,t⫹1 ( pi,t⫹1 ⫺ c i) mjiD p p 
p̃it p c i ⫺
b (1 ⫺ Sit ⫺ 冘j(i mjip pSjt)
⫹ r1

jp1
j(i
it it j(i mjip pSjt) .

(10)
Dpp pp
In the above equation, m is as defined in equation (9), while m param-
ji ji
eters are the contemporaneous CPs. An interesting feature of the pricing
equation above is that the presence of DCPs creates pricing dynamics in
addition to advertising dynamics. In other words, although there are no explicit
price dynamics built into the model, firms’ accounting for rivals’ reactions
induce an intertemporal linkage in their pricing decisions. If mjiD p p p 0, we
are back to the nonadaptive case.
The adaptive solution for advertising yields the following:
A˜ it p Mg
i ( pit ⫺ c i) Sit 1 ⫺ Sit ⫺
( 冘j(i
mjiAASjt ⫺ v1i
)
冘 
冘 
⬁ N
⫹Mg r j t⫺1 ( p ⫺ c ) S [j (1 ⫺ mjiAA) ⫺ mjiDAA] Sj,t⫹t . (11)

i  t i,t⫹t i i,t⫹t
tp1
 jp1 
 j(i 
In the above equation, mjiDAA is the advertising DCP, whereas mjiAA is the con-
temporaneous CP. Again, with zero DCPs, we are back to the nonadaptive
case. To interpret the DCPs, we rewrite the equilibrium price and advertising
levels for the adaptive case (eqq. [10] and [11]) as follows:
 冘 S (1 ⫺ S ⫺ 冘
 N Si,t⫹1 Sj,t⫹1 ( pi,t⫹1 ⫺ c i) mjiD p p 
p̃it p p ⫹ r1
,
∗
it (10 )
jp1 it it j(i mjip pSjt)
 j(i 
and
冘 冘
⬁ N
 
A˜ it p A it∗ ⫺ Mg
i
tp1

rtj t⫺1 ( pi,t⫹t ⫺ c i) Si,t⫹t
jp1
j(i
mjiDAASj,t⫹t ,


(11 )
∗ ∗
where p and A are the nonadaptive equilibrium price and advertising given
it it
by equations (6) and (7), respectively.
The above equations (10) and (11) provide the justification for our adaptive
equilibrium. Specifically, they indicate that when the DCPs are all zero, the
adaptive equilibrium simplifies to the nonadaptive one—which we know is
the open-loop, or precommitment, equilibrium. Hence, the DCPs capture de-
viations from the open-loop equilibrium in a manner that accounts for firms’
intertemporal reactions to one other.
Consider now the price DCPs. If mjiD p p is positive, then p˜ it 1 pit∗. That is,

49.248.73.41 on Sun, 03 Mar 2019 06:14:20 UTC
positive DCPs imply that firms are interacting in a manner that results in
equilibrium prices that are higher than those under nonadaptive behavior.
Consequently, the firms’ price/cost margins are also higher. What is it that
could result in positive DCPs? We note that when firms repeatedly interact
in the market, they could adopt a competitive stance that “softens” price
competition. Evidence of this type of tacit collusion has been provided in
several empirical studies (e.g., Kadiyali 1996). If, however, the DCPs are all
negative, then p̃it ! pit∗, implying aggressive pricing behavior on the part of
the market rivals. If the DCP is positive for one firm but negative for the
other, then one firm is being accommodating, while the other is being ag-
gressive. Of course, which of these conditions prevail in the market is an
empirical question.
Turning our attention now to the advertising DCPs, we note that if they
are all positive, then Ãit ! A it∗. That is, when the advertising DCPs are positive,
the equilibrium advertising level under the adaptive decision rule is less than
that under the nonadaptive case.4 Hence, firms can “soften” advertising com-
petition by appropriate conduct. As with price competition, this softer stance
can be brought about by repeated interaction in the marketplace. If the DCPs
are all negative, then the level of advertising competition is higher, relative
to the nonadaptive case. Mixed forms of interaction result when one DCP is
positive and the other is negative. The empirical results show which condition
prevails in the market.
III. Estimating Equations

In this section, we discuss how we go from the market-share and firm-
optimization rules discussed above to the estimating equations, as well as the
process used to document the effects of accounting for endogeneity. In the
empirical estimation, to determine the effects of endogeneity and simultaneity
of price and advertising decisions of firms, we use the following procedure:
1. Estimate the system of demand equation (1) alone, treating price and
advertising as exogenous variables.
2. Estimate the system of demand equation (1) alone, using three-stage
least squares (3SLS) and treating price and advertising as endogenous
variables.
3. Estimate demand equation (1), pricing equation (6), and advertising
equation (7) simultaneously, using 3SLS, where price, advertising, and
shares are treated as endogenous variables. Advertising has dynamic
effects, but competition is nonadaptive.
4. Estimate demand equation (1), pricing equation (10), and advertising
equation (11) simultaneously, where prices, advertising, and shares are
4. We reiterate that under both the adaptive and nonadaptive cases, the equilibrium advertising
level is higher than the static case because of the advertising carryover effect.

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treated as endogenous variables. Thus, we account for endogeneity and

simultaneity, while allowing for general forms of competition as de-
scribed in the adaptive equilibrium.
In the estimation, we convert the share equation to a logistic regression.
We do not have data on the outside good for two of the three product categories
(hair care and coffee), and, therefore, brand intercepts are all relative to the
Nth brand. Further, because we observe advertising GRP levels only and not
the cumulative advertising variable, we need to eliminate the CAit variable in
favor of the advertising levels Ait. This is accomplished by taking the 1-period
lagged equation ln Si,t⫺1, multiplying it by j, and subtracting it from ln Sit
(much like the Koyck transformation). This yields the following equation.
ln Sit p a i (1 ⫺ j) ⫹ ln SNt ⫺ j ln SN,t⫺1 ⫹ j ln Si,t⫺1 ⫹ b(pit ⫺ j pi,t⫺1 )
⫺ b(pNt ⫺ j pN,t⫺1 ) ⫹ g(A it ⫺ ANt ) ⫹ d(rit ⫺ jri,t⫺1 )

⫺ d(rNt ⫺ rN,t⫺1 ) ⫹ ␧ 3it ; i p 1, 2, … , N ⫺ 1,
where a i p a i ⫺ aN, and ␧ 3i is the associated error term. We estimate V p
{j, b, g, d, a¯ i , i p 1, 2, … , N ⫺ 1}. For the adaptive equilibrium case, price and
advertising equations for i p 1, 2, … , N are estimated as follows:
 冘 S (1 ⫺ S ⫺ 冘
1  N Si,t⫹1 Sj,t⫹1 ( pi,t⫹1 ⫺ c i) mjiD p p 
pit ⫺ c i ⫹
b (1 ⫺ Sit ⫺ 冘j(i mjip pSjt)
⫺ r1

jp1
j(i
it it j(i mjip pSjt) p␧

4it ;
A it ⫺ Mg
i (pit ⫺ c i) Sit 1 ⫺ Sit ⫺
( 冘
j(i
mjiAASjt ⫹ v1i
)
冘 
冘 
⬁ N
⫺ Mg r j t⫺1 (p ⫺ c ) S [j (1 ⫺ mjiAA) ⫺ mjiDAA] Sj,t⫹t p ␧ 5it .

i  t i,t⫹t i i,t⫹t
tp1
 jp1 
 j(i 
The associated error terms are ␧ 4i and ␧ 5i. The terms ␧it p (␧ 3it , ␧ 4it , ␧ 5it )
are intended to account for econometric error.5 When demand, price, and
advertising equations are estimated simultaneously, we assume that ␧ 3i, ␧ 4i,
and ␧ 5i are joint-normally distributed and may be contemporaneously, although
not temporally, correlated. We note the following features of the model spec-
ification:
1. The nonadaptive price and advertising levels are nested within the
adaptive price and advertising levels, that is, when all the DCPs p 0
in the nonadaptive case. If even one DCP is not equal to zero, the
adaptive model is a better description of firm behavior.
5. Some studies have interpreted the error term in the demand equation as stemming from
brand-specific temporal shocks (see, e.g., Besanko et al. 1998). Likewise, the error terms in the
price and advertising equations could be a result of either demand shocks or cost shocks or both.

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2. The static price and advertising levels are nested within the nonadaptive
price and advertising levels, that is, when j p 0 in the nonadaptive
case. This too can be tested econometrically.
The above system of equations consists of N ⫺ 1 demand equations, N
pricing equations, and N advertising equations, for a total of 3N ⫺ 1 equations.
The variable T denotes the empirically determined upper bound for the number
of terms retained in the pricing and advertising equations. This would depend
upon the firms’ discount rates. Note from the above system of equations
that the ACF parameters, v1i and v2i , and the market size parameter, M, are
not all uniquely identified. What can be estimated are Mi p M/(2v2i ) and
v1i p v1i /(2v2i ).
Another issue we face is regarding the number of time periods T to be included
in the analysis. Operationally, we did the following in determining T:
1. We started with t p 1 and increased t in increments of one.
2. Using a likelihood ratio test, we stopped at the value of t from which
an increase did not result in a significant improvement in model fit.
3. Given the finite time horizon, we set the discount factor, r p 1. This
facilitated quick and easy convergence of the estimation algorithm from
several starting points.
One of the issues that we need to address in the dynamic case is the number
of parameters to be estimated. For one of the product categories we consider,
yogurt, we focus only on price competition because we do not have access
to data on advertising. For this category, we estimate only the contempora-
neous CPs. For the other three cases, we analyze both price and advertising
competition. Given the paucity of data, that is, the number of observations
available for estimation, we set all the contemporaneous CPs p 0 in the
estimation for these three data sets. Given that our focus is on the dynamic
aspects of firm behavior in the presence of advertising, it is important to
demonstrate the effect of adaptive versus nonadaptive behavior. We recognize
that our estimates would be affected to the extent that we do not include the
effects of the CPs in this case. Additionally, for two of the four data sets, we
do not have enough data to estimate all of the DCPs. Therefore, for these
data, we estimate the system with various combinations of DCPs to see which
ones are insignificant, and we set those to zero to save degrees of freedom.
Other estimation restrictions imposed because of the paucity of data are the
equality of marginal costs and advertising costs across firms.
IV. Data
We use three different data sets in this study. Below, we describe details about
each of them. There are several differences across these product categories
that make these data sets interesting for our purpose. The categories vary
from food to nonfood, perishables to nonperishables, and those with only price

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to those with price and advertising competition. Also, the data frequency is
of two types—weekly and monthly—and there are data from local as well as
national markets. This diversity of data will be useful in generating some
insights into the effects of endogeneity and simultaneity on the estimated price
and advertising effects. Table 1 shows the descriptive statistics for these data.
A. Yogurt
We study weekly price competition in the yogurt category. Hence, there are
no DCPs in this case, and we estimate only the contemporaneous CPs. The
(scanner) data on prices, sales, and feature/display activities are for Springfield,
MO, for 102 weeks in 1986–88. These data are pooled over stores. There are
four brands in this data set—Dannon, Yoplait, Weight Watchers, and Hiland.
Using data from the household file for the same market, we obtain no-purchase
information, which we use as a measure of an outside good for the estimation
of brand intercepts. An issue with examining competition among national
brands from data of a local market is the role of the retailer in setting prices
(Sudhir 2001b). Following Besanko et al. (1998), we assume that the retailer
charges a fixed markup over manufacturer prices while determining the prices
to the consumer.6 A critical issue in the estimation is the choice of instruments
for price. Consistent with the Besanko et al. study, we chose cost-side vari-
ables. These variables are the costs of fluid milk, container prices (plastic),
and labor-costs data taken from the Bureau of Labor Statistics (BLS).
B. A Hair-Care Product
The data available are weekly data over a 2-year period for three brands of
a hair-care product with the highest market shares in that subcategory. For
reasons of data confidentiality, we cannot reveal either the brand names or
the specific product category. The variables included are unit market shares,
retail prices, advertising GRPs, and a couponing variable. The last variable
is the total value of coupon drops in each week. Further, the variable is lagged
by 1 week to capture the delayed effect of manufacturer coupons and is scaled
by a factor of 10⫺4. For purposes of this analysis, we assume that the couponing
variable is exogenous. This assumption may be reasonable because coupon
drops are often planned well in advance and then executed according to a
predetermined schedule. Given these data, we study price and advertising
competition in the category.
The data are aggregated across stores and chains to the national level, so
individual retailer behavior and interactions among retailers are not easily
addressed. Because prices are at retail, and we have nationally aggregated
data, we assume as before that retail prices reflect fixed markups over man-
ufacturer wholesale prices. This facilitates the use of our proposed model
6. We treat feature/display activities as exogenous to manufacturers. We recognize that future

research needs to address this issue.

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TABLE 1 Descriptive Statistics

Variable Mean SD
Yogurt:
Price of brand 1 (1/10 dollar per oz.) .80 .09
Price of brand 2 1.04 .15
Price of brand 3 .52 .07
Sales of brand 1 (oz.) 2,635.79 2,049.05
Sales of brand 2 1,418.96 1,440.03
Sales of brand 3 1,471.84 2,308.79
Sales of brand 4 629.22 854.83
Feature/display of brand 1 (% store weeks) .05 .21
Feature/display of brand 2 .06 .23
Price index of fluid milk 103.95 1.72
Price index of packaging material 111.08 1.11
Labor costs 9.71 .16
Hair-care product:
Advertising GRPs of brand 1 69.50 67.77
Sales of brand 1 897,355.83 128,337.86
Sales of brand 2 1,323,094.27 158,197.09
Sales of brand 3 1,622,034.07 217,887.79
Coupons of brand 1 .02 .07
Price index of inorganic chemicals 118.54 1.66
Price index of packaging materials 111.08 1.11
Labor costs 9.71 .16
National coffee market:
Price of brand 1 (dollars per oz.) .29 .07
Sales of brand 1 (oz.) 1,700,956.29 172,350.30
Sales of brand 2 964,626.55 112,467.08
Sales of brand 3 411,852.74 36,412.06
Proportion of brand 1 sold on promotion .39 .11
Price index of Robusta beans 83.37 47.21
Regional coffee market:
Price of brand 1 (dollars per oz.) .34 .08
Advertising GRPs of brand 1 (#.01) 3.93 3.08
Market share of brand 1 .31 .06

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TABLE 1 (Continued )
Variable Mean SD
Price of brand 1 in other markets .31 .09
Advertising GRPs of brand 1 in other markets (#.01) 3.41 2.66
Price index of Robusta beans 83.37 47.21
formulation. The weekly nature of the data also drives our choice of time
interval (i.e., week) for the analysis.
As instrumental variables for price, we used the costs of packaging (plastics)
and inorganic chemicals (major ingredients of the product). These data are
also from the BLS. For advertising, the ideal choice of instruments would
have been weekly advertising costs. Unfortunately, we did not have access
to those data. Therefore, we use lagged couponing as an instrument for ad-
vertising.
As mentioned previously, we had to impose the restriction of equality of
marginal costs and advertising costs across brands. In the absence of these
restrictions, we were unable to estimate the parameters of interest, possibly
because of insufficient degrees of freedom. (With these restrictions, this cat-
egory has one less parameter to estimate relative to the yogurt category, while
the number of data points for yogurt is 701 compared to 114 for this category.)
Clearly, if more data observations were available, such restrictions may not
be needed.7
C. Coffee
The third data set we use is monthly data on a subcategory in coffee. Again,
for data confidentiality reasons, we cannot reveal the subcategory or the brands
in it. An interesting feature about coffee data is that it is available to us at
two levels of aggregation—at the national level and at a regional level. We
also have data on average price and advertising GRPs for all markets other
than the single regional market for which we have data. Therefore, following
Nevo (2001), we can use marketing variables from the average of all other
markets as instruments for those in the regional market. Other instruments
used in the regional market and in the national market include price of (Ro-
busta) coffee beans and lagged promotions.
For this category, too, we had to impose estimation restrictions. We have
only 35 (monthly) data points for this category, compared to 114 for the hair-
care category and 701 in the yogurt category. Therefore, more restrictions
7. We note that the contemporaneous CPs have already been set to zero for all categories
except yogurt.

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were required for parameter estimation. First, as we did with the hair-care
product, we impose the restrictions of equality of marginal costs and adver-
tising costs. Second, by repeated estimation, we determined which CPs were
insignificant and then set them to zero in the final estimation. Clearly, if more
data points were available, there would not be a need for such restrictions.
An important issue that arises in the context of the hair-care and coffee
data sets is that we do not have measures of the outside good and focus on
brand shares conditional on category purchase. This has several consequences.
First, the elasticities obtained from the analysis will not be true demand
elasticities because category expansion is not accounted for. Second, recall
our assumption that the total market size, M, remains constant over time in
our model development. For this assumption to be tenable, it must be the case
that the total sales in the (sub-) categories of interest are not sensitive to the
prices and advertising levels of the brands included in the analysis. Accord-
ingly, to verify this, we regressed total (sub-) category sales in each case on
the average price and total advertising level across brands. For both the hair-
care and coffee categories, we did not obtain statistically significant effects.
Hence, our assumption on the market size appears reasonable, at least for the
data at hand.
In summary, we have different kinds of products with different numbers
of observations in the categories. In all cases, we used input costs as instru-
ments for prices. Additionally, where multimarket data are available (as in
the regional coffee market), we use outside market advertising levels as in-
struments for in-market advertising. In the absence of such data, we used
lagged values of the promotional variables.
Prior to discussing the results for the estimation, we note that they are
conditioned on our assumption regarding the role of the retailer in setting
prices. We assumed that the retailer plays only a passive role and sets prices
using fixed markup rules. The importance of the role of the retailer and the
consequences of ignoring it are likely to be dependent on the level of market
aggregation in the data. That is, one would expect that where the data pertain
to a local market, the role of the retailer in price setting is likely to be
significant. However, with national U.S.-level data, the role of the retailer in
price setting is likely to be less important. Hence, by having different data
sets that cover different levels of market aggregation, we can determine
whether our results regarding endogeneity and simultaneity are robust to the
assumption we have regarding the role of the retailer in price setting.
V. Results
A. Preliminary
The results of the estimation are presented in table 2 for yogurt, table 3 for
the hair-care product, table 4 for coffee with national data, and table 5 for

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TABLE 2 Results for Yogurt

Demand Equations Only Demand and Pricing Equation
Endogenous
Exogenous Price, 3SLS Nash Conduct
Price Results Behavior Parameter
(1) (2) (3) (4)
Demand parameters:
Brand 1 intercept ⫺.23 .35 3.22* 2.88*
Brand 2 intercept ⫺.39* .37 4.07* 3.63*
Brand 3 intercept ⫺1.90* ⫺1.53* .33* .11
Brand 4 intercept ⫺2.06* ⫺1.50* 1.26* .93*
Price effect ⫺3.05* ⫺3.75* ⫺7.29* ⫺6.87*
Promotion effect 1.12* .74* .15 .18
Costs:
Marginal cost of brand 1 . . . . . . .49* .41*
Conduct parameters:
P1 w.r.t. P2 . . . . . . . . . 1.89*
P1 w.r.t. P3 . . . . . . . . . 2.49*
P1 w.r.t. P4 . . . . . . . . . 1.67*
P2 w.r.t. P1 . . . . . . . . . 2.45*
P2 w.r.t. P3 . . . . . . . . . 3.86*
P2 w.r.t. P4 . . . . . . . . . 2.87*
P3 w.r.t. P1 . . . . . . . . . 1.99*
P3 w.r.t. P2 . . . . . . . . . 2.36*
P3 w.r.t. P4 . . . . . . . . . 2.36*
P4 w.r.t. P1 . . . . . . . . . 1.24*
P4 w.r.t. P2 . . . . . . . . . 1.75*
P4 w.r.t. P3 . . . . . . . . . .53*
Note.—P1 p price 1; P2 p price 2; P3 p price 3; P4 p price 4; w.r.t. p with respect to.
* Statistically significantly different from zero at the 5% level of significance.
coffee with regional data. Rather than describe results for each product cat-
egory, we describe results across categories.
Regarding the time-period length chosen, as described in the previous sec-
tion, we carried out the three-step procedure described previously to determine
T. We note that a higher value of T does not increase the number of parameters
to be estimated. Hence, it might seem reasonable that a higher T would fit
the data better. However, this is not necessarily the case because increasing
T with no additional parameters would also place greater restrictions on the
same set of parameters. Indeed, we found that T p 1 captures the dynamics
for both the hair-care product and coffee.
B. Accounting for Endogeneity and Simultaneity

We first discuss the results obtained from the demand-function-only analysis.
The objective here is to compare the estimated price and advertising effects
under the exogenous and endogenous formulations (cols. 1 and 2 in tables 2–5).
We note that the estimated price effects are larger in each case when price is

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TABLE 3 Results for the Hair-Care Category

Demand Equations Only Demand and Optimization Rules
Endogenous Static Adver-
Exogenous Price and tising Effects, Dynamic Dynamic
Price and Advertising, Nash Advertising, Advertising,
Advertising 3SLS Results Behavior Nonadaptive Adaptive
(1) (2) (3) (4) (5)
Demand parameters:
Brand 1 intercept ⫺.40* ⫺.31 1.01* 5.18* .14
Brand 2 intercept ⫺.01 .06 1.37* 5.45* .51*
Advertising effect .23* .72** .34 ⫺.37 .59**
Price effect ⫺.39* ⫺.56** ⫺3.59* ⫺13.24* ⫺1.58*
Promotion effect .16* .17* .16* .09 .07
Advertising carry-
over effect .16* .30* . . . .90* .55*
Cost:
Marginal cost of
brands . . . . . . 1.96* 2.28* 1.72*
Conduct parameters:
P1 w.r.t. P2 . . . . . . . . . . . . ⫺.36
P1 w.r.t. P3 . . . . . . . . . . . . 3.91*
P2 w.r.t. P1 . . . . . . . . . . . . .00
P2 w.r.t. P3 . . . . . . . . . . . . ⫺5.82*
P3 w.r.t. P1 . . . . . . . . . . . . .00
P3 w.r.t. P2 . . . . . . . . . . . . ⫺.07
A1 w.r.t. A2 . . . . . . . . . . . . 4.03
A1 w.r.t. A3 . . . . . . . . . . . . ⫺18.75
A2 w.r.t. A1 . . . . . . . . . . . . ⫺1.10
A2 w.r.t. A3 . . . . . . . . . . . . 13.59
A3 w.r.t. A1 . . . . . . . . . . . . ⫺.06
A3 w.r.t. A2 . . . . . . . . . . . . ⫺3.31*
Note.—A1 p ad 1; A2 p ad 2; A3 p ad 3; P1 p price 1; P2 p price 2; P3 p price 3; w.r.t. p with
respect to.
** Statistically significantly different from zero at the 10% level of significance.
treated as being endogenous. This finding is consistent with the Besanko et

al. (1998) finding. There is no obvious trend in the other parameters.
Next, consider the results when we account for both endogeneity and si-
multaneity. These estimates are in columns 3–5. Here, there are two cases for
yogurt—when Nash behavior is imposed versus when the more general CP
model is estimated. For the hair-care product and coffee, with nonadaptive
formulation, we will test both the static and dynamic advertising-effects models.
Before introducing the results for accounting for the Nash behavior of
competitors, we would like to simplify further discussion by considering first
whether advertising has static or dynamic effects. For the hair-care product,
the difference in their objective function values is 12.27. The critical x2 value
with 1 degree of freedom (difference in number of parameters estimated) at
95% confidence is 3.84. For national coffee, the difference in objective func-
tions is 13.21, and for regional coffee data, it is 4.66. Therefore, for all data
sets with advertising data, the dynamic nonadaptive behavior formulation is

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TABLE 4 Results for Coffee Using National Data

(1) (2) (3) (4) (5)
Demand parameters:
Brand 1 intercept 1.34* 1.29* 1.49* 1.63* 1.61*
Brand 2 intercept .77* .87* 1.01* 1.28* 1.23*
Advertising effect .00 .17* .16* .06* .06*
Price effect ⫺.48 ⫺2.29* ⫺4.60* ⫺9.05* ⫺8.24*
Promotion effect .46* .34** .02 ⫺.04 .02
Advertising carry-
over effect .67* .77** . . . .88* .86*
Cost:
Marginal cost of
brands . . . . . . ⫺.06* .10* .12*
Conduct parameters:
P1 w.r.t. P2
(restricted p 0) . . . . . . . . . . . . . . .
P1 w.r.t. P3
(restricted p 0) . . . . . . . . . . . . . . .
P2 w.r.t. P1 . . . . . . . . . . . . ⫺.43*
P2 w.r.t. P3
(restricted p 0) . . . . . . . . . . . . . . .
P3 w.r.t. P1 . . . . . . . . . . . . ⫺.33
P3 w.r.t. P2
(restricted p 0) . . . . . . . . . . . . . . .
A1 w.r.t. A2 . . . . . . . . . . . . ⫺1.65*
A1 w.r.t. A3
(restricted p 0) . . . . . . . . . . . . . . .
A2 w.r.t. A1 . . . . . . . . . . . . ⫺1.65*
A2 w.r.t. A3
(restricted p 0) . . . . . . . . . . . . . . .
A3 w.r.t. A1 . . . . . . . . . . . . .37
A3 w.r.t. A2
(restricted p 0) . . . . . . . . . . . . . . .
respect to.
a better description of firm behavior than the static advertising-effects model

of firm behavior.
Next, we would like to compare the adaptive versus nonadaptive response
results, given that dynamic advertising effects capture the data better than
static effects. If players behave in a nonadaptive manner, then all mijD p p p
mijDAA p 0. A model with these restrictions imposed is nested within the adap-
tive model. For the hair-care product, the objective function value for this
nonadaptive model is 265.9, while that for the adaptive specification is 175.3.
The critical x2 value with 10 degrees of freedom (difference in number of
parameters estimated) at the 95% level of significance is 18.31. The computed
test-statistic value of 90.6 is thus larger than the critical value. Hence, the

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TABLE 5 Results for Coffee Using Regional Data

(1) (2) (3) (4) (5)
Demand parameters:
Brand 1 intercept 1.14* 1.26* 1.10* 1.14* 1.55*
Brand 2 intercept 1.09* 1.19* 1.03* 1.09* 1.57*
Advertising effect .01** .01* .02* .02* .01**
Price effect ⫺2.25* ⫺4.39* ⫺2.06* ⫺2.43* ⫺7.73*
Promotion effect 1.19* .58** 1.41* 1.07* ⫺.19*
Advertising carry-
over effect .34* .81* . . . .37* .80*
Cost:
Marginal cost of
brands . . . . . . ⫺.23* ⫺.23* .07*
Conduct parameters:
P1 w.r.t. P2 . . . . . . . . . . . . .53*
P1 w.r.t. P3
(restricted p 0) . . . . . . . . . . . . . . .
P2 w.r.t. P1 . . . . . . . . . . . . .56*
P2 w.r.t. P3
(restricted p 0) . . . . . . . . . . . . . . .
P3 w.r.t. P1 . . . . . . . . . . . . .43*
P3 w.r.t. P2
(restricted p 0) . . . . . . . . . . . . . . .
A1 w.r.t. A2 . . . . . . . . . . . . ⫺.96*
A1 w.r.t. A3
(restricted p 0) . . . . . . . . . . . . . . .
A2 w.r.t. A1 . . . . . . . . . . . . ⫺1.15*
A2 w.r.t. A3
(restricted p 0) . . . . . . . . . . . . . . .
A3 w.r.t. A1 . . . . . . . . . . . . ⫺2.45*
A3 w.r.t. A2
(restricted p 0) . . . . . . . . . . . . . . .
respect to.
nonadaptive equilibrium can be rejected in favor of the adaptive equilibrium.

For national coffee data, the computed test-statistic value is 20.08, and the
critical x2 value with 5 degrees of freedom is 11.07 for the 95% level of
significance. We thus reject the nonadaptive formulation for that data too. For
the regional coffee data, the computed value is 10.71. The critical value with
6 degrees of freedom at 90% confidence is 10.64, at 95%, 12.59. Therefore,
adaptive behavior cannot be rejected at the 90% level of significance.
We now discuss the implications of accounting for endogeneity and simul-
taneity. Comparing the results in columns 1 and 2 against those in column 3
for yogurt and column 4 for the hair-care product and coffee, we see that
accounting for the simultaneity of price increases the estimated price parameter

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by a large amount. This is especially interesting because, in each of these

cases, we used aggregate data rather than individual household-level data.
Researchers in marketing have documented how aggregate data lead to lower
price elasticities than when household data are used (Christen et al. 1997).
However, these researchers accounted for neither endogeneity nor simultaneity
of price outcomes. Using four different data sets, we find that while accounting
for endogeneity increases the price parameter somewhat, accounting for si-
multaneity increases price effects to magnitudes much closer to those estimated
using household data. This is the case even when a strong behavioral as-
sumption of Nash behavior is imposed on the data.
To examine the effects of a general model of firm competition, we compare
for the yogurt category the results of column 4 in table 2 with those in columns
1–3. For the hair-care product and coffee categories (tables 3–5), we compare
the results in column 5 to those in the other columns of each table. In other
words, the last column in each table is the general model accounting for
endogeneity and simultaneity with flexible competitive conduct. Once again
we see that price effects are much larger in this case than in column 1, where
neither endogeneity nor simultaneity have been accounted for. In three of four
cases, however (i.e., except regional coffee data), the effect is smaller than if
Nash behavior was imposed. Therefore, estimates of price responses with
Nash behavior are likely to be biased upward. The advertising effects are
stronger in this case than in column 1 with no endogeneity and simultaneity,
except for regional coffee data where it is equal to the column 1 estimates.
We also find that price effects are considerably understated if advertising
dynamics are not accounted for in the estimation. These results extend the
Besanko et al. (1998) findings. Those authors concluded that ignoring en-
dogeneity would affect such inferences. Our results indicate that ignoring
dynamics when present could also lead to misleading inferences.
Hausman (1978) Specification Test

As mentioned previously, a critical issue in estimating a demand-and-supply
model is that in such models, a misspecification of the supply-side equations
can bias estimates of demand-side parameters as well. To ensure that this is
not the case, we performed a Hausman (1978) specification test. That is, we
compared the two-stage least squares (2SLS) estimates of demand to the 3SLS
estimates of demand obtained from estimating demand and supply simulta-
neously. Under the null hypothesis of no misspecification of supply-side equa-
tions, both the 2SLS and 3SLS estimates are consistent and unbiased. Under
the alternative hypothesis of misspecification, the 2SLS estimates are unbiased,
but the 3SLS estimates are biased because the misspecification in the first-
order conditions corrupts the demand-function estimates. The empirical results
of the Hausman specification tests were as follows. For yogurt, the critical x2
value with 6 degrees of freedom (equal to the dimensionality of the variance-
covariance matrix) at 95% confidence is 12.59. The computed value is 12.4,
which implies that we cannot reject the null of no misspecification at 95%

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confidence. For the hair-care product, the computed x2 value is 7.53. For the
national coffee data, the estimated x2 test-statistic value is 8.23, and for the
regional coffee data it is 8.07. The critical value is (with 6 degrees of freedom)
again 12.59 at 95% confidence. Therefore, we cannot reject the null of no
misspecification at 95% confidence in each case. We conclude, based on the
Hausman specification test, that in all four data sets, the supply-function
specifications are not causing the demand-side parameters to be biased.
Another way of determining whether accounting for endogeneity and si-
multaneity along with a flexible form of competitive conduct among firms
makes sense is to examine whether the parameters under this estimation are
more intuitive than in the other scenarios. Consider table 2. We see that for
yogurt, the brand-specific utility intercepts in column 1 are all negative (relative
to the outside good), whereas in column 4 they are all positive, and three out
of the four are significant. In table 3 for the hair-care product, column 4 contains
the implausible result of insignificant advertising effects but a positive and
significant advertising carryover effect. However, the estimates given in col-
umn 5 show both a significant advertising effect as well as a significant
carryover effect. Additionally, the carryover parameter seems unreasonably
high at 0.90 in column 4 when Nash interaction is imposed but seems more
reasonable at 0.55 in column 5 (see Leone 1995). In table 4, for the national
coffee data, we see that the marginal-cost estimate is negative with static
advertising effects (col. 3) but is positive in column 5. Similarly, in table 5,
for the regional coffee data, the marginal-cost estimate is negative for both
columns 3 and 4 and is positive only for column 5. Hence, from the standpoint
of the face validity of the parameter estimates, the formulation with a flexible
form of competitive interaction is more appealing than imposing Nash behavior.
Summarizing the results of both the specification tests and the reasonable-
ness of the parameter estimates, the formulation with both endogeneity and
simultaneity, as well as a flexible-form firm interaction, seems to econo-
metrically produce “the best” set of parameter estimates. This result under-
scores the need for accounting for all those issues, even when the primary
focus of the empirical analysis is on obtaining accurate estimates of the demand
effects of the marketing-mix variables.
C. The Supply Side: Competitive Conduct and Cost Parameters

Although an analysis of the cost and competitive structure is not the primary
focus of this study, we will, nevertheless, make some brief remarks about
both of them. For the yogurt data, all the estimated cost parameters are less
than prices, as expected. We also see “cooperative” pricing among the firms
because all of the mjip p parameters are positive, which results in margins greater
than those under Nash pricing behavior. Margins are large, ranging from 61.7%
for the brand with the largest intrinsic preference (brand 2) to 27% for the
one with lowest intrinsic brand preference (brand 3).
In the hair-care product, the estimated marginal cost is less than the prices

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of all three brands. Most DCPs are not significantly different from zero.8 The
exceptions are that firm 1 prices cooperatively with respect to firm 3, whereas
firm 2 prices competitively with respect to firm 3. The only significant ad-
vertising DCP is of firm 3 advertising aggressively with respect to firm 2.
Given that we are unable to estimate firm-specific marginal costs, we cannot
determine the relationship between these DCPs and marginal costs. However,
firm 1’s cooperative pricing is consistent with its lowest intrinsic brand pref-
erence and its lowest market share. This cooperative pricing translates to the
highest prices charged. Firm 3’s aggressive advertising is consistent with its
highest intrinsic brand preference, its lowest prices, and its highest advertising
GRPs.
For the national coffee data, the only significant interaction is that firm 2
prices competitively with respect to firm 3. Its aggressive stance is consistent
with firm 2’s larger intrinsic brand preference and its larger market share. In
advertising, firms 1 and 2 advertise competitively with respect to one another.
Given firm 1’s much larger market share and larger intrinsic brand preference,
as well as its larger GRPs, it is not clear why firm 2 should advertise ag-
gressively relative to firm 1. The marginal-cost estimate is below prices for
all three firms.
For regional coffee data, we see a different competitive pattern than for
national data. This is not surprising, given that the demand and cost conditions
vary across markets. Firm 2 prices cooperatively to firm 1’s prices, and firm
1 to firm 2’s. In this market, firm 2 has more market share than firm 1 and
also has higher intrinsic brand preference and higher GRPs than brand 1.
However, firms 1 and 2 have the same market price. Firm 3 prices cooper-
atively to firm 1’s prices. Firm 3 is the smallest, with the lowest price and
the lowest advertising GRPs, and, therefore, cooperative pricing is profitable
for firm 3. Advertising competition is more intense than price competition,
with all three significant DCPs being negative.
We also find that for the coffee data, more of the advertising DCPs are
significant with the regional data relative to the national data (three vs. one).
Further, we find that there is no pattern of significant advertising DCPs with
respect to the choice of data intervals (weekly or monthly when we look
across all four data sets). These results seem to suggest that the estimated
interaction among firms seems to be more a function of the level of market
aggregation than the data interval.
The results from the coffee category also reveal that some of our marginal-
cost estimates are negative and statistically different from zero. Clearly, this
is unreasonable, so what might be an explanation for this finding? Note from
tables 4 and 5 that the negative marginal-cost effects are always accompanied
8. Note that some of the DCP parameters in table 3 that are not statistically different from
zero have large magnitudes; e.g., A1 with respect to A3 is ⫺18.75. We redid the estimation by
fixing all the nonsignificant DCP parameters to zero to see whether they had an affect on our
other reported results. We find that while the magnitudes of some of the other parameters change
somewhat, the nature of our results remains the same.

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by price coefficients that are closer in magnitude to zero, as compared to

those from the dynamic adaptive-advertising case. What this means is that
when endogeneity is not fully accounted for, price effects are biased toward
zero, and consequently, markups predicted by the corresponding models are
“too large.” The only way the model can reconcile large markups with ob-
served price levels is by implying negative marginal costs. Hence, these es-
timates are a consequence of the endogeneity issue not being fully addressed
in the model and estimation.
Summarizing, the supply-side estimation is not only critical to estimating
econometrically accurate demand-side parameters; it also enables a better
understanding of the equilibrium competitive-market structure. We find that
there are significant departures from Nash competitive interaction in all cases,
implying that such an assumption may be unreasonable, irrespective of the
product category, level of market aggregation, or length of the data interval
used in the analysis.
VI. Discussion and Conclusion

Marketers have used the logit to model household choice behavior, treating
manufacturer choices of price and advertising as exogenous. Recently, re-
searchers have demonstrated that it is important to account for endogeneity.
Using four different data sets with different products, market-level aggrega-
tions, and periodicity characteristics, we find in our analysis that accounting
for endogeneity avoids biased estimates for marketing activities. However, to
obtain efficient estimates, we also need to account for the optimization rules
for price and advertising decisions. We also find that, compared to all other
scenarios, estimating flexible competitive behavior produces the most intuitive
parameters on both the demand and cost sides. These results are robust for
data that differ in several ways—national versus regional versus local markets,
weekly versus monthly data, perishables versus nonperishables, food versus
nonfood items, and those with and those without advertising data.
These results are interesting for at least two reasons. First, modelers who
do not model either endogeneity or simultaneity need to be aware of the biases
in the estimates of their parameters. Our results show that even if the principal
objective of the study is not one of understanding how decisions regarding
the marketing-mix variables are made, we must account for endogeneity in
order to obtain unbiased estimates of managerially important measures such
as price and advertising elasticities. Second, the insights gained on the com-
petitive side complete the picture of why market equilibria are the way they
are—a product of demand and supply-side forces.
Going beyond the issue of incorporating endogeneity, our results indicate
that incorporating the simultaneity in price and advertising leads to more
efficient parameter estimates. Intuitively, this result comes about because in-
corporating simultaneity is akin to increasing the number of data points for
estimation because in addition to the demand equations, there are also the

49.248.73.41 on Sun, 03 Mar 2019 06:14:20 UTC
price and advertising equations that can be exploited in the estimation. Cross-
equation restrictions reduce the number of independent parameters that need
to be estimated and provide extra information that can be used in efficient
estimation.
There are a number of possible avenues for future research. First, an im-
portant issue in using an aggregate logit model is that of heterogeneity in the
response parameters (see Berry 1994; Berry et al. 1995; Nevo 2001; Sudhir
2001a). We do not address that issue due to the additional complexities created
and the consequent inability to study equilibrium advertising behavior. Nev-
ertheless, some recent research is attempting to address this issue (e.g., Dube,
Hitsch, and Manchanda 2003). Future research should relax the assumption
of a passive retailer. This may not be an appropriate assumption for pricing
decisions where retailers use any type of category-management system. Under
such a system, a constant markup rule is not likely to prevail, and the observed
retail prices will have to reflect the retailer’s decision-making process. In order
to accomplish that task, the data used in the empirical analysis will have to
contain information on manufacturer transfer or wholesale prices (or alter-
natively, the retailer margins on each brand). However, obtaining such data
for research is not an easy task.
Second, the analysis needs to be extended to other instruments of firm
competition and incorporate richer demand specifications. We have chosen
very simple demand specifications here for reasons of tractability. For ex-
ample, one might want to use a more complex demand specification that
incorporates a measure of brand loyalty, which is a function of past purchases,
weighted exponentially. That greatly complicates obtaining estimable first-
order conditions. Nevertheless, future research needs to find ways to handle
such formulations.
In summary, in this article we have attempted to provide a benchmark study
of important effects and issues that must be considered when analyzing ag-
gregate logit models of demand. Ignoring such effects can lead to biased
parameter estimates of the effects of price and advertising on demand. We
hope that future research will pursue these issues further and provide additional
empirical generalizations that could assist marketing managers in choosing
how to implement their marketing-mix decisions.
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Endogeneity and Simultaneity in Competitive Pricing and Advertising: A Logit Demand

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Endogeneity and Simultaneity in

I. Introduction In this article, we use

(Journal of Business, 2006, vol. 79, no. 6)

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side”? Typically, a firm is assumed to maximize some objective function, for

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lation is relatively straightforward. In a recent study, Vilcassim, Kadiyali, and

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simultaneity to the advertising domain. In particular, we obtain approximate

II. Model Formulation

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Open-Loop (Nonadaptive) Solution

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Nash (which we refer to simply as “Nash”) equilibrium pricing.2 We refer to

i ( pit ⫺ c i) Sit 1 ⫺ Sit ⫺

Adaptive Solution (or General Form of Competition)

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characterize Markov-perfect equilibria (Pakes 1998). However, these methods

3. The general dynamic programming problem is given by Bellman’s equation as follows:

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The key difference between the necessary conditions in equations (6)–(8)

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The D in the above DCPs refers to “dynamic.” As before, deriving the

⫹Mg r j t⫺1 ( p ⫺ c ) S [j (1 ⫺ mjiAA) ⫺ mjiDAA] Sj,t⫹t . (11)

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III. Estimating Equations

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treated as endogenous variables. Thus, we account for endogeneity and

⫺ b(pNt ⫺ j pN,t⫺1 ) ⫹ g(A it ⫺ ANt ) ⫹ d(rit ⫺ jri,t⫺1 )

⫺ Mg r j t⫺1 (p ⫺ c ) S [j (1 ⫺ mjiAA) ⫺ mjiDAA] Sj,t⫹t p ␧ 5it .

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6. We treat feature/display activities as exogenous to manufacturers. We recognize that future

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TABLE 1 Descriptive Statistics

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TABLE 2 Results for Yogurt

B. Accounting for Endogeneity and Simultaneity

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TABLE 3 Results for the Hair-Care Category

treated as being endogenous. This finding is consistent with the Besanko et

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TABLE 4 Results for Coffee Using National Data

a better description of firm behavior than the static advertising-effects model

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TABLE 5 Results for Coffee Using Regional Data

nonadaptive equilibrium can be rejected in favor of the adaptive equilibrium.

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by a large amount. This is especially interesting because, in each of these

Hausman (1978) Specification Test

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C. The Supply Side: Competitive Conduct and Cost Parameters

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