Informative Advertising with Differentiated Products

Author(s): Gene M. Grossman and Carl Shapiro

Source: The Review of Economic Studies , Jan., 1984, Vol. 51, No. 1 (Jan., 1984), pp. 63-
81
Published by: Oxford University Press

Stable URL: https://www.jstor.org/stable/2297705

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide
range of content in a trusted digital archive. We use information technology and tools to increase productivity and
facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at
https://about.jstor.org/terms

Oxford University Press is collaborating with JSTOR to digitize, preserve and extend access to
The Review of Economic Studies

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
Review of Economic Studies (1984) LI, 63-81 0034-6527/84/0050063$00.50
? 1984 The Society for Economic Analysis Limited

Informative Advertising with

Differentiated Products
GENE M. GROSSMAN and CARL SHAPIRO
Princeton University

In this paper we study the role of promotional expenditures by sellers in a model of product
differentiation. Advertising conveys full and accurate information about the characteristics of
products. Heterogeneous consumers, who have no source of information other than advertise-
ments, seek to purchase the products that best fit their needs. Despite the roles played by
advertising in improving the matching of products and consumers, and in increasing the elasticity
of demand faced by each firm, we find that the market-determined levels of advertising are
excessive, given the extent of diversity in the market.
We derive a promotional equilibrium based on a specific information transmission tech-
nology, paying explicit attention to the structure of consumer information and its impact on firms'
demand curves. This allows us to study the effects of changes in the advertising technology.
including an increased ability to target messages to specific groups of consumers, on the equilibrium
in the product market. We find that decreased advertising costs may reduce profits by increasing
the severity of price competition.

1. INTRODUCTION

An important aspect of competition in differentiated product markets is promotional

competition. The presently rapid rate of change in the technology of advertising, and
information transmission generally, suggests that the importance of this type of competi-
tion can only grow in the future.
The goal of this paper is to investigate the role of advertising in markets with product
differentiation. One question of particular interest regards the effect that changes in
advertising costs have on the market equilibrium. We hope to identify, for example, the
various impacts that improvements in the ability to target messages to specific groups of
consumers will have on consumer product markets. Continued improvement in targeting
opportunities is likely to be an outgrowth of the current expansion in the set of available
media, which makes narrow-casting more and more possible.
It is sometimes maintained that advertising levels are excessive; i.e. greater than
those which would prevail in the socially optimal allocation. Our second major objective
is to see whether, in the context of a formal model of a differentiated-product market,
this view is borne out by a welfare analysis.
One reason that advertising levels are thought to be excessive is that advertising
influences consumer preferences; i.e. it is "persuasive." Dixit and Norman (1978, 1981)
have shown that advertising of this sort is carried out at an excessive level in the market
under fairly weak conditions, even if the post-advertising demands are used to measure
consumer surplus.
We do not wish to deal with persuasive advertising in what follows. Rather, we
model advertising in a way that takes a very favourable view of its content. We assume
that an advertisement provides full and truthful information about the product it promotes,
while leaving consumers' tastes unchanged. Furthermore, we assume that the consumer

63

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
64 REVIEW OF ECONOMIC STUDIES

has no alternative sources of information, and is un

brand unless she sees an ad describing it.'
Our approach is to embed this view of advertising in a familiar model of product
differentiation. In this setting, advertising is used by each firm as a competitive tool to
attract customers away from other firms. The view that advertising redistributes con-
sumers among firms underlies the popular perception of wasteful advertising. Where
products are homogeneous, this socially unproductive expense of resources is undoubtedly
the predominant effect of advertising, because once a consumer is aware of at least one
brand, the social benefits of more ads to that consumer are zero (if all firms charge the
same price) or small, and are most probably smaller than the private returns. But studying
advertising in a homogeneous product setting is inappropriate and possibly misleading.
If products are heterogeneous, we must take into account the social benefit deriving from
the improved matching of consumers and brands that occurs when consumer information
is more complete. In addition, advertising may play a role in making the market more
"competitive" by increasing the elasticity of demand for each particular brand.
In the analysis below, we are able to compare the sizes of these various effects, and
judge which is likely to be more important. We study the nature of the biases in the
market equilibrium under the alternative market-structure assumptions of oligopoly (with
a fixed number of firms) and free-entry (with zero profits). The oligopoly treatment may
be viewed as a short-run analysis of a market in which there are no entry barriers.
A novel aspect of our analysis is the careful attention we pay to the transmission of
information from the individual firm to the individual consumer. We consider the demand
curve facing each firm as a function of the prices and advertising intensities of other firms.
This demand curve is derived from the underlying preferences of consumers across brands,
and the technology by which consumers receive messages (ads) from sellers. This
approach, which is in contrast to the common reduced form specification in which
advertising expenditures appear as a parameter in the demand function, allows us to
study changes in advertising more directly.
In the next section we derive the individual firm's demand curve and compute the
oligopoly and monopolistically competitive equilibria. In Section 3 we study the compara-
tive static properties of these equilibria. Then we turn to the welfare analysis in Section
4. A brief conclusion follows.

2. A MODEL OF ADVERTISING AND PRODUCT DIFFERENTIATION

In this section we specify a model of advertising in a market for heterogen

We choose a familiar type of product diffentiation in order to focus attent
played by advertising in the competitive equilibrium.

A. A description of the model

The product space and consumer preferences

We seek to study advertising in a context where it plays a role in matching heterogeneous

consumers to products that suit their tastes.

To do so, we employ the product characteristics approach to product differentiation

associated with Lancaster (1975), and developed by Salop (1979).2 By analogy to spatial
competition, we represent each product as a point on a circle of unit length.3 Each
consumer is identified by the point on the circle which corresponds to her most preferred

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 65

brand. We assume that each consumer has use for at most one unit in the product class
being studied, and attaches a gross dollar value of v to a unit of her most preferred
brand. A product which is at a distance z along the circle from a consumer provides a
dollar benefit of v-tz, where we refer to t as the transport cost (per unit distance), bearing
in mind the locational competition interpretation of the circle model. The parameter t,
then, measures the sensitivity of consumers to product characteristics.
The consumer surplus enjoyed by a consumer who purchases a product a distance
z units away at price p is v-tz-p. Consumers purchase a unit in this product class only
if they are aware of the existence of a brand offering positive surplus. If the consumer
knows of several such brands, she selects that brand offering the greatest surplus. Finally,
we assume that consumers are uniformly distributed around the circle with a constant
density of a consumers per unit length.

The production technology

The importance of economies of scale in the context of differentiated products is well

understood; there is a basic tradeoff between scale economies and the value of diversity.
We employ, therefore, a very simple cost structure exhibiting increasing returns to scale.
A fixed cost, F > 0, is required to develop a product and to set up the facilities to produce,
distribute and sell the brand. Actual production is subject to constant returns to scale
with a marginal cost of c > 0. Each firm produces at most a single brand.

Information structure

We focus on product-specific information as supplied by sellers. To do so, we employ

an information technology similar to that in Butters (1977). Consumers, who may or
may not know the structure of the product market (that is, that there are n symmetrically-
distributed brands on the unit circle of product characteristics), rely on information
garnered from ads to locate specific brands in product space. In other words, a consumer
may know that a product with certain characteristics exists in the market, but she does
not know a priori which firm produces and sells goods of a given specification. An
advertisement tells the consumer the characteristics and price of a particular brand. We
assume that consumers remember all advertising messages that are successfully transmitted
to them.
Each consumer is passive in that she does not search for a brand which suits her
taste, nor does she engage in other active information acquisition activities. Iniplicitly,
we are assuming that the cost of search is high relative to the surplus offered by goods
in this product group. Thus, each consumer has information about all and only those
brands which she has seen advertised at least once.4

Advertising technology

Advertising messages are produced by the same firms that manufacutre the goods. Firms
choose to make the content of their messages truthful, as our model provides no incentive
for deceptive advertising.
Initially, we assume that a seller has no ability to target messages towards those
consumers who find his product most attractive (i.e. those consumers nearby on the
circle). The costs of advertising are left quite general. The per capita expenditure needed
to achieve a reach of k, 0 + _ 1, is denoted by A(?; a). Here a is a shift parameter
which we use below to investigate changes in the advertising technology. A reach of 4

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
66 REVIEW OF ECONOMIC STUDIES

means that a fraction k of the target population is exposed to the message (at least once).
Given our no targeting assumption, this implies that each consumer receives the message
with probability 4. Since the total population size is 8, the advertising costs (for a given
firm) are given by 8A(4; a).
We assume that AO > 0 and A,? > 0. The latter assumption reflects the notio
it becomes increasingly expensive to reach higher fractions of the population, either
because preferred media become saturated, or because the target population is
heterogeneous along a second dimension, namely, the tendency to view ads. We also
assume, without loss of generality, that A(O; a) =0.5

Advertising technology: An example

In order to understand the nature of the advertising cost function A(?, a) and to show
that our assumptions about it are natural ones, we derive an example for a specific
technology of message production. Consider the case where an advertiser can place ads
in any of a set of magazines or newspapers. Assume that each magazine has a readership
of Sr in the target population of size 8, so that a fraction r of the population is exposed
to an ad published in any given magazine.6
Let us assume that the probability that a given consumer sees an ad in one magazine
is independent of the probability that she sees an ad in another magazine; that is, that
different magazines have independent readerships. Then if the advertiser places ads in
m magazines, the probability that a given consumer will see none of these ads is (1 - r) m.
The reach of such an advertising campaign is 0 = 1- (1- r)m. Equivalently, we can write
the number of magazines in which ads must be placed in order to achieve a reach of k
as m = log (1- +)/log (1-r).
What is the cost of achieving a given reach of 4? Let us suppose that each magazine
charges a fixed amount, a, per reader. Then placing an ad in a single magazine will cost
a8r, and the cost of a campaign running in m magazines is a8rm. Therefore, the cost of
achieving a reach of 0, which requires m = log (1- +)/log (1 - r) ads, is

SA( a =a8r
8A( c)-log (1log
- ) (1-r) (1)

We will refer to this advertising cost function as the constant-reach, independent-

readership (CRIR) technology.7 Note that this function has the properties we assume
for A(O; a); that is, A(0; a) =0, AO >0, A?? >0. In this example, the shift parameter,
a, can be identified with either a or r.

Equilibrium concept

The market equilibrium studied below is the non-cooperative Nash equilibrium in prices,
p, and advertising intensities, 4. This is an extension of the classic equilibrium concept
of monopolistic competition pioneered by Chamberlin (1931) to include advertising as
a strategic variable. We study only symmetric equilibria. In such an equilibrium each
firm takes as given the prices p and advertising levels k chosen by all other firms, and
selects its own p and 4 to maximize profits. We do not study location or product choice
competition. Instead, we assume (again following Salop, 1979) that whatever the number
of firms happens to be, they are equally spaced around the circle.
The symmetric equilibrium which takes as given the number of firms is called the
oligopoly equilibrium. If free entry and exit are allowed, profits are driven to zero, and

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 67

the number of firms is endogenously determined. We refer to this specification as the

monopolistically competitive equilibrium.

B. Equilibrium in the model

We turn now to the actual computation of equilibrium, both with a fixed number of firm
and with free entry. A necessary first step is the derivation of the demand curve facing
the representative firm, x(p, 4), given the prices p and advertising levels 4 of the other
firms. This calculation is more complex than under perfect information, because competi-
tion is no longer localized. A given firm may sell to a consumer far away from it on the
circle, if that consumer has not received an ad offering a more attractive sale.
Taking the number of firms as given for the moment, and given the representative
firm's price, p, and that of its (n-1) rivals, p, consumers can be partitioned into n groups,
k = 1, ... , n, where the kth group is that set of consumers to whom the representative
firm would offer the kth highest surplus of the n firms, were all consumers perfectly
informed. This partition is a useful one, because the probability that an ad results in a
sale will depend below only on the identity of the group to which the consumer receiving
the ad belongs. We now compute the sizes, Nk, of these n groups.
A consumer who is at distance z from the representative firm could achieve surplus
v-tz-p by purchasing from that firm. For 0_ z ' 1/n, i.e. for consumers between the firm
and its nearest neighbour, the best alternative to the representative firm is the neighbour,
who offers surplus of v-t(1/n-z) -p. Let z1 be the location of the consumer who
would be indifferent between these two alternatives if she were fully informed. z1 is
depicted in Figure 1, and is given algebraically by

V-tZ,-P= V-t 1-Zlj-p

Surplus

v-p

z~~~~~

I @ | v-p-tz

Zi Z2 1 Z3 2 3 Location
n 1n n

FIGURE 1

Surplus offered by representative firm and its nearest neighbours

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 68 REVIEW OF ECONOMIC STUDIES

or

P - p 1
2t 2n'

All those consumers with z - z1 would, if fully informed, find the product of the repre-
sentative firm to be their first choice.8 The total number of these consumers, counting
consumers located on either side of the firms, is

N1=28zl = +-P) . (2)

t n

Next consider the location of the consumer that would be indifferent between
purchasing the product of the representative firm and that of the next closest neighbour
(in the same direction). This consumer is at distance Z2 from the firm (again, see Figure
1), where

v-tz2-P= v-t(-z2) - p.
(n)

Therefore,

P-P 1
2t n

Those consumers between z1 and Z2 would, with complete information, find the product
of the representative firm to be their second-most preferred. The number of consumers
in this second group is N2= 28(z2- z1), or, since z2- z1 =1/2n, N2= 8/n. Repeating
this procedure yields

Zk=
Z=2t-22n+-k k=1,2, ... ,n-1,
and thus

Nk=- k=2,.. . , n-1. (3)

n

Finally, the n-th group comprises all those consumers not in the other (n-i) groups,
i.e. Nn= a- _k-' Nk, or

8n 8(--p) P(4)
n t

We are now prepared to compute the demand curve facing the representative firm.
If the probability of making a sale to a consumer in the k-th group is k, then demand
is given by

x(p, 0) = Nl 01 + N202+. * *+NnOn

A sale is always made to a consumer in the first group if she receives an ad, because no
other firm offers as much surplus to consumers in this group (by definition). Therefore,
+1= 4. Likewise, an ad to a consumer in the second group results in a sale if and only
if she has not received an ad from her most preferred brand. This occurs with probability
(1- k), and, thus, 02 = +(1 - 4). Now, if we assume that v is sufficiently large so that
the constraint that consumer's surplus be non-negative is never binding, then an ad

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 69

transmitted to a member of any group results in a sale for the representative firm whenever
the potential customer receives no better offer.9 In general, we have

Ok = o(l _ )k-l k = 1, 2, ... ., n. (5)

Substituting for the Nk's from (2), (3), and (4), and for the 4k'S from (5), into the
expression for demand, and summing, gives

x(p, ) sor(PP)
t
[1-(1-) ]+ [1_(1 n] (6)
n4~

Finally, for reasonable parameter values such that (1-4)f is small,10 an excellent
approximation to (6) is

x(p,+)= (P P)+-,. (7)

It is instructive to note that the elasticity of demand, E, evaluated at p = p, is given

by E = pn4l t. As usual, a greater number of firms raises the elasticity of demand faced
by any given firm. What is new is the appearance of 4 in the expression for E. This
reflects the intuitive notion that improved information (i.e. a large 4), increases
demand elasticities (and thus reduces prices).
The representative firm's optimal policy (i.e. choice of p and 4, given p, 4 and n)
is now readily computed. Profits for this firm are

v p, 0) = (p p-c)x( p, < )- F -AA(+). (8)

Using the approximation in (7), one first order condition (FOC) is

p(p, 4) = (p-c)(- ~ )+ t n

Solving this equation for p yields

+C t(9

P 2 2n4()
Note that this formula collapses to that derived by Salop (1979) under
when we replace k by 1. We find, therefore, that imperfect information, by reducing
demand elasticities, raises markups.
The second FOC is given by

X (p ?,) = 8(p - c) P) + j -8A a) = 0.

In the symmetric equilibrium p = p, so we get

P CA4(0; a). (10)

no
This condition has an intuitive interpretation. Since 48 consumers receive the representa-
tive firm's message, a small increase in 4 of do = 1/8 will inform (on average) one more
consumer. The probability that the consumer so informed will purchase from the firm
is (1/n)[1 + (1- 4) + (1 - )2+. * * + (1- _)n-l] ] 1/n4. Therefore, the small increase
in 4 will generate 1/n4 sales, which augments profits by (p-c)/n4. Equation (10)
states that this marginal private gain be equal to the marginal private cost, A0 (4;

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
70 REVIEW OF ECONOMIC STUDIES

If we replace 4) and p, in (9) and (10) by 4 and p, we obtain two equations that
determine the symmetric oligopoly equilibrium, given the exogenous variables (including
n). These two equations are

t
p-c=-, (hla)
no

p - c = nOA0 (0, a). (l lb)

The symmetric, monopolistically competitive equilibrium is determined by these two
equations, and the free-entry condition, which says that profits are zero. This equation,
which makes n now an endogenous variable, is given by'2

(P C)8 -F + A(o; a). (1 lc)

n

This completes the derivation of the oligopoly and monopolistically competitive

equilibria. We turn now to an investigation of their comparative static properties (which
are summarized in Table I below).

3. COMPARATIVE STATICS

A. Oligopoly

The effects of changes in the exogenous parameters on the oligopoly equilibrium prices
and advertising levels are most easily derived by first substituting (1 la) into (1 lb) to give
a single equation in 4:

422A.(4); a) = tln2. (12)

An increase in the number of firms (and brands) leads to a reduction in equilibrium
advertising intensities (since A0,0 > 0, the left-hand side of (12) is increasing in 4). This
is because an increase in competition tends to reduce the yield on a given firm's ads, as
customers are more likely to get word of a brand better suited to their tastes. This is
consistent with the observation that advertising is especially important in industries that
are relatively concentrated.
The effect of product diversity (n) on markups is as expected: d(p- c)/dn < 0. This
can be seen by rewriting (12) as

(no )2AO (4, a) = t, (12')

and noting that as n increases, since 4 and the
Inspection of (lla) reveals that a rise in no implie
words, the direct, positive effect on competition caused by an increase in the number of
firms dominates the induced negative effect associated with the consequent reduction in
advertising intensities.
Increases in t, which reflect increased sensitivity of consumers to product specifica-
tions, lead to increases in 4 (by (12)). Thus, when product differentiation is more
important, so too is advertising. Markups also increase with transport costs, due to the
fact that the elasticity of demand falls as t rises.
Finally, we consider changes in the advertising technology. By the usual convention,
we choose our parameterization such that Aa > 0 and A,,,, > 0. Increases in a correspond
to increases in total and marginal advertising costs. In our example of the CRIR advertising
technology, a might represent the cost per exposure (which we called a). Then A(4, a)

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 71

would be of the form aA(O). For future reference, we defi

respect to 4, /3 = A,a/Aa, and the elasticity of A,0 with r
In the case of A(O,a)=aA(O), A,0,0 >0 implies that /
7> 0.
Changes in the cost of advertising are particularly relevant today due to the introduc-
tion of new media (e.g. cable television), which permit advertisers to send messages only
to those consumers who are most likely to purchase the product. Suppose that consumers
around the circle constitute only a fraction of the overall consumer population, and that
consumers not located on the circle attach no value to goods in this product group. If
we interpret a as the fraction of messages which go to consumers who are not interested
in the product group, then an increased ability to target advertisements to the relevant
population is captured by a decrease in a. Targeting leads to a decline in the effective
cost of getting a message to the relevant consumers. Alternatively, we can think of
targeting as the ability of a firm to send ads specifically to those consumers who lie within
a distance A <2 of the firm's product on the circle. This is also formally equivalent to a
decrease in a, because ads sent to consumers far away on the circle, which were formerly
wasted so long as An is moderately large, are no longer sent. We are therefore able to
study the effect on product markets of media proliferation (and of improved information
about the correspondence between demographic characteristics and demand, as needed
for targeting) via changes in the advertising cost function.
Totally differentiating equation (12'), we find that d4/da = -Ap,g,/(2Aci, +
OA,p,p) < 0; i.e. if the marginal cost of reach rises, the reach (per firm) in the market falls.
Then, differentiating (l la) and substituting (12) gives d(p - c)/da = - nAp(do/da) > 0;
increases in advertising costs cause markups to rise. This reflects the pro-competitive
effect of advertising via improved information.
Do profits per firm rise or fall with increases in the cost of advertising? Writing the
change in profits per firm as

diTr = P -+x--8Aegx
-(p-c) )dx +Xdp _Bpd4_SA
--8AA
da da da da

and recognizing that across sy

d= AaA [2(83-1)-71] (13)

da 71+2

The expression in the brackets cannot be signed in general. On the one hand, an increase
in a directly increases costs, and thus tends to reduce profits. On the other hand, an
increase in advertising costs reduces the degree of competition as measured by demand
elasticities and hence increases markups. For example, if A(4, a) can be written as
aA()), then 8 > 1, and it is possible to have profits increase with advertising costs. This
is an example of a potential cost-based facilitating practice; that is, it may be in the
interests of oligopolists to raise advertising costs.13 It is sometimes argued, for exampl
that cigarette manufacturers have benefitted from their exclusion from television adver-
tising.
Equation (13) makes intuitive sense, because a large value of -q means that it is
expensive at the margin to change the reach. Therefore, when a rises, 4 falls only
slightly, and the direct cost effect dominates the decreased competition effect. We note
that when a specifically represents the cost per exposure, a, in the CRIR advertising
technology, one can show that diT/da < 0, unambiguously, so the "normal" result applies.

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
72 REVIEW OF ECONOMIC STUDIES

B. Monopolistic competition

The free-entry equilibrium values of p, 4 and n are defined by equations (lla), (llb),
and (llc). It is convenient to eliminate (p-c) from these equations to reduce the
equilibrium conditions to the following two equations in the variables n and 4:

422AO(4), a) = tln2 (, =O), (14a)

Of + OA(o, a) = tln2 (Ir = O). (14b)
Here we have also introduced f Fl8.14 These curves are depi
It is not hard to prove that the two curves intersect as shown in the figure.

I \ 7rO

7r=O

nm n

FIGURE 2

Monopolistically competitive equilibrium

It is also possible to eliminate n to obtain a single equation for the market level of
advertising, )m, which is15

0AO (4, a) = f +A(4, a). (15)

The effect on the equilibrium of an increase in fixed costs (f), for example, can be
found using the diagram. As fixed costs increase, the zero-profits locus shifts to the left.
This causes 4 to rise and n to fall. An increase in fixed costs causes firms to exit. With
fewer firms, the benefits of advertising grow (i.e. the probability that an ad results in a
sale increases), and advertising intensity (per firm) rises. It can also be shown that
d(p - c)/ df> 0; i.e. that with fewer firms left to compete markups must increase.
We are especially interested in the impact of changes in the advertising technology.
An increase in a effects a downward shift in the iiO = 0 schedule; at a given n increased
marginal costs of advertising reduces advertising levels. At the same time a rise in a
causes the zero-profits curve to move to the left; at a fixed advertising intensity per firm
increased advertising costs reduce profits and cause exit from the industry. The net effect
of these two shifts must be derived analytically.
Using (15) it is straightforward to show that sgn do/ da = sgn (1 -,8), where /8 is the
elasticity of A,, with respect to 4 as defined above. In the case where A(4, a) = aA(4),
as, for example, when a measures cost per exposure, we have /8> 1 and therefore

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 73

do/da < 0. This is certainly the most plausible result where

cost of advertising reduce advertising levels.
The effect of increased advertising costs on prices is unambiguously positive. This
is due to the direct cost effect; prices must rise to cover added advertising expenses. This
effect is reinforced when d4)/ da <0, for in that case the reduction in reach reduces
elasticities of demand. Even when do/da > 0, however, dp/da > 0.
Finally, we compute dn/ da to see how changes in advertising costs affect diversity
in the product market. As is intuitive, an increase in advertising costs causes entry exactly
in those circumstances when it effects an increase in profits in the oligopoly equilibrium;
i.e.

sgn dn/da = sgn [2(,8 -1)-r] =sgn d T

Again we have the possibility that improvements in advertising technology will result in
exit, and thus fewer brands in the monopolistically competitive equilibrium.
The comparative static results for both the oligopoly and monopolistically competitive
equilibria are summarized in Table I. To check the validity of these results in the absence
of the large-group approximation, we have simulated the model using the functional form
for A(4, a) derived from the CRIR technology and choosing parameter values such that
n falls in the range of five to ten. In all cases we found the comparative static results
indicated in the table to be valid.16

TABLE I

Comparative static results

Endogenous variables
Oligopoly Monopolistic competition

P p n

F 0 0 - + + -
Exogenous t + + + + 0 +
variables a + - ?1 + ?2 9

Notes:
1.- sgn (2(0 - 1) -,q).
2. sgn (1 -3,8)( < 0 if A(0, a) = aAA(0)).

4. WELFARE ANALYSIS

In this section, we investigate the nature of the biases that arise in the mark
relative to the outcome that would be socially optimal. We begin, in the first subsection,
by deriving the socially optimal allocation of resources. Then, in subsection B, we compare
the level of advertising that obtains in the market to the level that maximizes social
welfare, given the (same) extent of diversity in each case. First we note that the monopoly
case (that is, n = 1) of our model is a special case of Shapiro (1980). Therefore we know
that the monopolist always under-provides informative advertising. This finding serves
as a useful basis for comparison with our result for the oligopoly equilibrium, given
parameter values such that (1 - ))n is small. Under this large-gfoup assumption, advertis-
ing levels for each firm are always excessive.

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
74 REVIEW OF ECONOMIC STUDIES

In subsection C, we compare the free-entry monopolistically-competitive equilibrium

to the full social optimum (with the number of firms endogenous). The Salop (1979)
finding that the market overprovides diversity is extended to our model with imperfect
information.

A. The socially optimal allocation

The welfare standard used here is the conventional one of consumer surplus plus profits,
or gross benefits to consumers less production and marketing costs. Aggregate welfare
is given by

W= (V-c)8[j_-(1-j_)n])-]nF - n8A() - T.

For notational ease, we now suppress a and write simply A(+), and A'(+) for
The first term in W represents benefits net of variable production costs, but gross
of transport costs. The term (1 - (1 - 0))n is the fraction of the population that consumes
the product. The second and third terms are fixed costs and marketing costs, respectively.
The final term, T, represents aggregate transport costs, and reflects the losses due to
imperfect product matching. We turn now to the computation of these costs.
To calculate T, we again partition the population into n groups, where the k-th
group is those consumers who would find a given, representative brand to be their k-th
most preferred under perfect information. The average travelling distance among con-
sumers who actually receive an ad from their closest brand is z = 1/4n. (These consumers
vary in distance from zero to 1/2n from their favourite brand.) Similarly, Z2, the average
transport distance of those who hear of their second closest (but not first closest) brand
is 3/4n. In general, Zk = (2k - 1)/4n, for k = 1, 2,... , n.
As we have shown above, the fraction of consumers in the first group is 4) =4); in
the second group is 4)2 = 4)(1 - 4); and in the k-th group is k = 4(1 - 0)k-1. A fraction
40 = (1 _ 4))n receives no messages. Thus, the average distance travelled by all consumers
can be written as

Z= En (kZk =k=l ) n (2k-i1)

z-kl4kz k=1 4)44)k

Summing this series,'7 we have

z=- , (-)(-tn+2(1+ On))]

4n4)

or, for (1 _ 4)n small, the approximation z = (2- 4))/4n4n

thus approximately T = 8tf = 8t(2 - 4))/4n4.
Returning to the expression for social welfare, and assuming henceforth that (1- _))
is sufficiently small, we now have

W=(v-c)8-nF-n8A(4)- -4 (2- 4). (17)

4n4)

The socially optimal n and 4 are defined by the two first-order conditions for the
maximization of W, which after rearranging (recall f- Fl ) can be written as

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 75

Of + A(o) = 2 (1- +) (W.n= 0) (18b)

It is possible to eliminate n from these two equations to arrive at the following single
equation in 0:

0 1-) =Af+A(4). (19)

This equation indicates that the optimal reach per firm, 4*, depends only on the
size of fixed costs relative to the market, f, and on the advertising technology. In fact,
using the second-order conditions for the social optimum, it can be shown that d+*/ df > 0
i.e. as fixed costs rise each firm should advertise more. This goes along with the expected
result that dn*/ df< 0; i.e. increased fixed costs reduce the optimal extent of diversity.
Finally, it is worth noting that Wn < 0; i.e. the marginal social benefits of advertising
(per firm) are smaller when the extent of diversity is greater.

B. Comparison of the equilibrium and optimal levels of advertising: Diversity given

In this subsection we compare the level of advertising per firm in the oligopoly equilibrium
with the level that would be socially optimal, given the extent of diversity (n). There
are four distinct effects which will in general cause divergences between the equilibrium
and the optimum:
First, to the extent which advertising reaches consumers who would otherwise be
uninformed, (that is, to the extent advertising increases the total market size), it tends
to be undersupplied. The reason is easiest to see in the case of a monopoly seller (n = 1).
When considering an increase in his advertising budget, the monopolist sees the benefit
as arising from additional sales, each of which he values according to its marginal
contribution to profit: p - c. Yet an additional sale typically generates consumer surplus
as well (v - p - tz) so the social benefits of advertising (v - c - tz) exceed the private
benefits (p - c). This effect implies that a monopolist will always underprovide purely
informative advertising, and was proven in Shapiro (1980). We call this the market-size
effect.
Second, the private and social benefits of sending a message to a consumer who has
already received a message from another firm generally differ. The social benefit arises
due to the improved matching of consumers with brands due to improved information.
It is easy to verify that aggregate transport costs are declining with 4. Call this the
matching effect.
The private benefit from advertising, however, comes in the form of the profit
contribution made by an additional customer. An individual firm does not account for
the profit reduction at other firms as it increases its advertising intensity and captures
customers from its rivals. We call this the customer-capture effect.
It is far from obvious a priori which of the matching and the customer-capture effects
is the dominant one. If the capture effect is the larger, advertising will tend to be
oversupplied.
Finally, increases in advertising levels promote price competition by raising firms'
demand elasticities. This is generally a beneficial effect of informative advertising, but
does not have direct welfare effects in our model due to our assumptions of inelastic
demand and no dropping out by consumers.

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 76 REVIEW OF ECONOMIC STUDIES

In the monopoly case, only the market size effect applies, and advertising is undersup-
plied. As the number of firms increases, however, the market size effect rapidly diminishes,
and the matching and capture effects become the dominant ones. By looking at the large
group case, such that (1- _)) is small,18 we therefore focus on these latter two effects.
To see which of the effects is dominant, we need only compare the socially-optimal
level of advertising per firm, as given implicitly in equation (1 8a), with the equilibrium
level determined by (14a). On the left-hand side of each of these equations is the
expression OiA'(O). This term is an increasing function of 4. The right-hand
(14a) is, given n, unambiguously larger than the right-hand side of (18a). It follows that
for the large-group oligopoly case, 4)m> 0*, that is, advertising intensity per firm in the
market equilibrium is excessive.
What we have shown is that when there are a sufficiently large number of firms in
a differentiated-product industry such that a marginal increase in reach per firm has no
significant effect on the total number of consumers informed about at least one brand,
then the beneficial effect of improved matching of consumers and products is outweighed
by the "wasteful" aspect of merely shuffling consumers among firms. The capture effect
outweighs the matching effect. Even though advertising is purely informative and has
positive social value, the private returns to advertising always exceed the social returns.
Of course, when n is not large, this statement must be qualified, since the market may
then leave too many consumers totally uniformed. However, we have found in our
simulations conducted over a wide range of parameter values that, even for n on the
order of four or five, the market equilibrium exhibits excessive advertising per firm.

C. Comparison of the monopolistically competitive equilibrium and the full social optimum

In this subsection, we compare the market equilibrium to the socially optimal allocation
of resources, when the number of firms, and therefore the extent of diversity, is taken
to be endogenous in each case. Salop (1979) has shown that the market provides excessive
diversity in a differentiated-product model with circular product space and complete
information. Our purpose here is to show that his results extend to our model with
imperfect information. This is so despite the fact that competition is no longer localized
in our model.
The analysis, which assumes once again that (1-4_))n is small, is performed by
comparing the two equations that determine 4)* and n*, equations (1 8a) and (1 8b), with
those that define 4)m and nm, equations (14a) and (14b). The results are displayed in
Figure 3 below.
In the figure, (18a) is located by an equiproportionate leftward shift of (14a), for
the reasons that were discussed in subsection B. Likewise, a comparison of (18b) and
(14b) reveals that the former lies everywhere to the southwest of the latter. Finally, to
show that the relative positions of the curves are as drawn, it is also necessary to prove
that 4)*> Om. This is accomplished as follows. Subtract equation (15) from equation
(19), and rearrange terms, to get

[A()*) - 4*A'(O*)]-[A(4)m) - 4)mA'(Om)]

2
= -*2 A(O*) <0. (2

Define H(O) = A(O) - OXA'()), and differentiate to see that H'(0))= -4A"(O) < 0.
Therefore, H(4)*) - H(om) < 0 in equation (20) implies that 0* > Om. Finally, the knowl-
edge that O* > Om allows us to compare n* and nm. The fact that n* < nm can be seen
from the figure, or shown analytically.19

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 77

n* n,n n

FIGURE 3

A comparison of the social optimum and the equilibrium

The fact that reach per firm in the full social optimum exceeds the level which obtains
in the monopolistically-competitive equilibrium should be interpreted with care. Since
increased diversity decreases the marginal social value of advertisements, (WO < 0),
finding that * > 'm is largely due to the fact that n * < nm. Nonetheless, it is interesting
to note that, while the social planner would want to cut back on the extent of diversity,
he would also wish to offset somewhat the deleterious effect of this reduction in n on
the average distance travelled by raising the informational reach of each of the remaining
products.

5. CONCLUSIONS

We have constructed a model of purely informative advertising with heterogeneous goods.

In our model, advertising does serve a useful social function; it informs customers about
brands' characteristics, and improves the matching of consumers and products. Neverthe-
less, we find that the advertising levels that prevail in the large-group oligopoly equilibrium
are always excessive.
We have also studied the effects of changes in the advertising technology on equili-
brium in product markets. This question has particular relevance at a time when the
availability of new media is decreasing the cost of reaching the target population. By
explicitly modelling the information transmission associated with advertising messages,
we found that improved efficiency of advertising (e.g. a reduction in the cost per exposure)
does indeed increase the competitiveness of the market (as measured by demand elas-
ticities) and causes prices to fall. We also derived a condition under which decreases in
advertising costs augment the degree of diversity in the market. This condition is satisfied
by the specific advertising cost function that we discussed in some detail, namely, that
associated with the constant-reach, independent readership technology.
Further research is necessary to test whether our results generalize to alternative
models of product differentiation. The circle model we have used is special, because it

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
78 REVIEW OF ECONOMIC STUDIES

implies that the extent of diversity in the market is always excessive under full information.
The incorporation of search behaviour or other information acquisition activities on the
part of consumers would also be an important extension of this analysis.

APPENDIX

Simulation results

We have simulated the model developed in the text in order to determine whether our
results apply for equilibria and optima with relatively few firms. In addition, the simula-
tions allow us to compare the relative sizes of some of the different effects we have
identified.
The equations for the monopolistically competitive equilibrium, which apply when
(1- _)n is not assumed to be small, are

(_ pc)[1-_(1-Inl =- [1_(1_O)n]; (Al)

no

(p- c)[l - (1 _ O)n] = nfA0 (k, a); (A2)

(p _-C)[1 _( 1- _)n] =n[ f + A(4X, a)]. (A3)
The equations that determine n* and k* in the social optimum are

f +A(q5, a)+(v-c)(l- )n log (1-_) = (1-4)n log (1-_ )[2+

t
+-[1-(1 +)n]* (A4)
2n

n(v- c)(l -_)fl = nAd,(G, a)-2 (p2 [1-(1-_)n]- (1-)n 1-n

We used the constant-reach, independent readership technology in equation (1) for

A(4, a) in our simulation. The parameter values selected for the base run are shown in
Table Al. These values were chosen to yield an equilibrium with an intermediate number
of firms, and a markup of somewhat less than 100% of variable cost. Note that the total
size of the market has been normalized at one, so each firm produces about 0 07 units
of the good. Variable costs are thus about five times fixed costs. In this base run,
promotional expenditures per firm are 1-86, or roughly one-half variable costs.

TABLE Al

Base case simulations

Parameters a = 3 t= 250 v = 250

r=01 f=075 c=50

Equilibrium Om = 048 nm = 14 Pm = 87
Optimum 0*=068 n*=6

The effects of changes in f, with the other parameters held fixed at their base case
values, are presented in Table All. The comparative static properties derived in the text
under the large n assumption are validated for n relatively small. We find that market

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 79

diversity and reach per firm are both quite sensitive in fixed cos
effected relatively less.

TABLE All

Variations in f

Equilibrium Optimum
f m nm Pm 0* n*

0 25 0-32 24 82 0 55 8
0 75 0 48 14 87 0-68 6
2-0 0-63 9 94 0 79 4
30 0-69 8 98 0-83 3

Changes in the advertising tech

reported in Table AIII. (Change in the reach per issue of the magazine, r, would enter
just like a, except that large values of r correspond to small values of a.) The comparative
static properties are again in line with those reported in Table I. Here, the most
pronounced effects of the changes in advertising technology are on advertising levels an
equilibrium prices. The effect on product diversity is almost negligible.

TABLE AIII

Variations in a

Equilibrium Optimum
a OkM n. Pm * n*

1 0 65 15 76 0-80 6
3 0-48 14 87 0-68 6
5 040 14 95 0-63 5
10 0-31 14 109 0.55 5

First version received July 1982, final ver

We thank Avinash Dixit, Ed Golding, Oli
Salop, Richard Schmalensee, Asher Wolinsk
and suggestions. This paper was revised while G. Grossman was a visitor at the Institute for International
Economic Studies, University of Stockholm, and C. Shapiro was a visitor at the Graduate School of Business,
Stanford University. We are grateful to those institutions for their support, and C. Shapiro is also happy to
acknowledge the support of the National Science Foundation.

NOTES
1. With this view of advertising, the Dixit and Norman result is reversed for a monopolist, as is shown
in Shapiro (1981). Monopolists engage in too little informative advertising of this type, because they fail to
appropriate the consumer surplus associated with informing additional consumers about their products.
2. A commonly used, alternative model of product differentiation is the representative-consumer approach
associated with Spence (1976) and Dixit and Stiglitz (1977). However, the notion of a representative consumer
is not well-suited to the introduction of an information technology in which firms send messages to individual
consumers who differ in their tastes across brands.
3. The spatial competition model is due originally to Hotelling (1929). Here we follow Salop (1979)
very closely, except that we do not assume perfect consumer information.
4. The absence from our model of search, word-of-mouth and experience as sources of information is
an important omission which we hope to rectify in future research. In principle, consumer search could be
incorporated in a manner similar to that in Butters (1977). See also Wolinsky (1982), who studies optimal
search behaviour in a model of differentiated products and imperfect information.

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 80 REVIEW OF ECONOMIC STUDIES

5. Any fixed costs of marketing can be incorporated in F.

6. Equivalently, we can imagine that everyone in the population "sees" the ad, but only a fraction r
remembers it.
7. An "issue of the magazine" can always be reinterpreted as a mailing of size r5. When r = 1/ 5 this is
just the sending of a single letter. As 5 grows, r -*0, and since

limr-O r/log (1- r) = -1,

A(+) then collapses to A(+) - a5 log (1 - 4). This is the technology used in Butters (1977), which is seen
to be a limiting case of ours.
8. This formula, and the ones which follow, hold only in the range p - t/ n < p < p + t/ n. We are a
that the parameters of the problem are such that it is neither profitable to reduce price to absorb a neighbour
(what Salop terms the supercompetitive region) nor to raise price so high so as to drive N1 to zero. The former
assumption can also be justified by the non-Nash behavioural assumption that a rival will reduce price rather
than have his prime group eliminated, while the latter assumption amounts to putting an upper bound on v.
Without these assumptions, an equilibrium may fail to exist.
9. In order to ensure that consumers will not drop out of the market if they do not receive an ad from
a brand that suits their tastes particularly well, it is necessary and sufficient that v - p - t/2> 0 be satisfied in
equilibrium, since the largest possible distance to any firm is 2
10. Dixit and Stiglitz (1977) made a similar "large-group" assumption in their investigation of monopolistic
competition and product differentiation. To check the closeness of our approximation, we have simulated the
equilibrium in this model for a wide range of parameter values and found that the error involved in going from
(6) to (7) is quite small and is generally several orders of magnitude smaller than the error involved in permitting
n to take on non-integral values. Analytically, our approximation becomes exact as n gets large if (and only
if) A'(0) = 0. The approximation is most accurate for n large (when n is taken as exogenous) and A'(O)/t
small. In the monopolistically-competitive equilibrium, a large n is generated by t large and F/I smal
We will, on occasion, refer to our simulations (described in detail in the appendix) to support the general
validity of our propositions even when the number of firms is small.
11. It is straightforward to check that the second-order conditions for profit maximization are satisfied
for each firm in the neighborhood of the symmetric equilibrium. The second-order conditions are also satisfied
for the 4 and p that solve equations (Al) and (A2) in the appendix, where we do not use the assumption that
(1 - 0)n is small.
12. This equation also assumes that (1- k)' is small enough to make (7) a good approximation. For
(1- _)n small, almost all customers are served in equilibrium, so each firm makes approximately 5/n sales.
13. Salop and Scheffman (1981) discuss cases when it is in the interest of a given firm or firms to raise
their own costs.
14. In fact, it should now be clear that F and 5 enter only as the ratio F/I; i.e. fixed costs should be
measured relative to the size of the market.
15. Equation (15) can be derived directly from equations (Al) and (A2) in the Appendix, where we do
not make the assumption that (1 _ k)n is small. Consequently, the value of 4 in the monopolistically-competitive
equilibrium is determined exactly by equation (15), and the comparative static results relating to this variable
are valid irrespective of the number of firms in the market.
16. See the Appendix for more detail on these simulations.
17. The derivation makes use of the fact that

E_ (k + 1)(1- d= l - _ (1-

18. Recall, from footnote 10, that (1- 4k)f will become small as the number of firms in the indus
becomes large provided that A,(O; a)/t is relatively small.
19. n *2 = t/24*2A'(4*) and n 2 = t/2 A'(O,n). Since k2A'(4) is increasing in 4 and 0*> >Om, it follows
that nm > n*.

REFERENCES
BUTTERS, G. (1977), "Equilibrium Distributions of Sales and Advertising Prices", Review of Economic
Studies, 44(3), 465-491.
CHAMBERLIN, E. H. (1929) The Theory of Monopolistic Competition (Cambridge: Harvard University Press).
DIXIT, A. K. and NORMAN, V. (1978), "Advertising and Welfare", The BellJournal of Economics,, 9(1), 1-17.
DIXIT, A. K. and NORMAN, V. (1981), "Advertising and Welfare: Reply", The Bell Journal of Economics,
12(2), 753-754.
DIXIT, A. K. and STIGLITZ, J. E. (1977), "Monopolistic Competition and Optimum Product Diversity",
American Economic Review, 67(3), 297-308.
HOTELLING, H. (1929), "Stability in Competition", The Economic Journal, 37(1), 41-57.
LANCASTER, K. (1975), "Socially Optimal Product Differentiation", American Economic Review, 65(4),
567-585.

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms
 GROSSMAN & SHAPIRO INFORMATIVE ADVERTISING 81

SALOP, S. (1979), "Monopolistic Competition with Outside Goods", The Bell Journal of Economics, 10(1),
141-156.
SALOP, S. and SCHEFFMAN, D. (1981), "Strategic Interaction in Multiple Markets: A Beginning to a
General Theory of Dominant Firm Industries" (mimeo, Federal Trade Commission).
SHAPIRO, C. (1980), "Advertising and Welfare: Comment", The Bell Journal of Economics, 12(2), 749-75 1.
SPENCE, A. M. (1976), "Product Selection, Fixed Costs, and Monopolistic Competition", The Review of
Economic Studies, 43(2), 217-236.
WOLINSKY, A. (1982), "Product Differentiation with Imperfect Information" (Hebrew University, Jerusalem,
mimeo).

This content downloaded from

154.59.124.111 on Sat, 01 Jun 2024 12:22:23 +00:00
All use subject to https://about.jstor.org/terms