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6.1. Information Asymmetry and Advertisement
Chapter Six
Advertisement, Research and Development
and Technology Progress
6.1. Information Asymmetry and Advertisement
• Advertising may convey hard facts, vague claims, or try to create a favorable
impression of a product.
• By convincing consumers that its product has certain desirable traits, a firm
can differentiate it from other products.
• As its product becomes differentiated, a firm may face a higher and less
elastic demand curve, so that it can charge a higher price and earn greater
profits.
• For example, one heavily promoted brand of soap sells at a much higher
price than many other soaps that are physically identical.
3 appliances such as refrigerators and washing machines.
• Advertising is a means of communication with the users of a product or
service.
• Advertisements are messages paid for by those who send them and are
intended to inform or influence people who receive them
• Advertising has many purposes:
• An advertisement may inform consumers that a firm has a new product
or the lowest price
• It may help to differentiate the firms product from that of its rivals.
• A firm uses advertisements to inform consumers of its product’s strengths
but not its weakness.
6.1. Information Asymmetry and Advertisement
 ‘’Search’’ versus’ Experience’’ Goods
• The informational content of advising depends on whether consumers can
determine the quality of a product prior to purchase (Nelson 1970, 1974).
• If a consumer can establish a product’s quality prior to purchase by
inspection, the product has search qualities
• Examples: are furniture, closeting (determine style), and other products
whose chief attributes can be determined by visual or facile inspection.
• If a customer must consume the product to determine its quality, it is said to
have experience qualities.
• Examples: Common examples include consume non durable convenience goods such
as beer, tooth paste, soap, cereal and consume durable goods including household
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6.1. Information Asymmetry and Advertisement
 ‘’Search’’ versus’ Experience’’ Goods
• Advertising provides direct information about the characteristics of
products with search qualities
• Advertisements for search products often include photographs. In some
cases a consumer cannot directly observe a physical attribute, but it can be
concisely described.
• In contrast, for experience goods, the most important information may be
conveyed simply by the presence of the advertising,
• Some advertisement do little more than mention the name of the firm to
enhance the firm’s reputation.
• Such advertisers hope that consumers infer the quality of reputability of a firm by
the frequency of its advertising and the expense involved
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6.1. Information Asymmetry and Advertisement
 Advertising and Profitability
• All advertising is designed to increase the demand for a firm’s product
whether facts are used or merely smoke and mirrors.
• An increase in informative or persuasive advertising expenditures
causes an out ward shift of the demand curve facing a firm
• The firm chooses its output, given its advertising expenditures, by
setting its marginal revenue with respect to quantity equal to its
marginal cost, MC.
• The out ward shift in the demand curve increases profits (not
adjusted for advertising expenditures). (see your class lecture notes for
graphs)
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6.1. Information Asymmetry and Advertisement
 Informational versus Persuasive Advertising
• Informational advertising:- describes a product’s objective characteristics
• For example, informational advertising may cite the price of a product,
compare the advertising store’s price of its rival’s prices, describe the
features of the product, or list its uses.
• Persuasive advertising:- is designed to shift consumer’s tastes
• Persuasive advertising may explicitly or implicitly make claims such as
“smoke these cigarettes to look more mature and sexier.’’
• Some companies may try to change consumers’ perceptions of their
product using persuasive advertising, when they could not truthfully change
their informative advertising.
6.2. Welfare Implications of Advertisement
 The Social Benefits and Costs of Adverting.
The Social Benefits of Advertising.
• Empirical evidence suggests that advertising about price, referred to as
price advertising, results in lower prices.
• Product differentiation puts pressure on manufacturers to produce high
quality products.
• Advertising may help manufactures take advantages of economics of scale
in production and distribution
• Advertising provides a social benefit by subsidizing the mass media.
• Most of the revenues received by new papers, magazines, radio, and
television are from advertising.
• Finally, advertising is an entertaining art form, and some of it is quite
good.
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6.2. Welfare Implications of Advertisement 6.2. Welfare Implications of Advertisement

 The Social Benefits and Costs of Adverting.
The Social Costs of Advertising.
• Few economists argue that informational advertising creates serious economic waste.
• Persuasive advertising is designed to create a subjective positive reaction to a product.
• Much of the advertising on television is persuasive.
• Persuasive advertising may provide valuable information about the quality of
experience goods.
• Although the social benefits of persuasive advertising maybe hard to identify, the
private benefits are obvious.
• Persuasive advertising may increase market power and economic profits.
• The social costs of persuasive advertising, therefore, may be substantial.
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 The Social Benefits and Costs of Adverting.
The Social Costs of Advertising.
• TOPIC FOR CLASS DISCUSSION
• Consider two producers of toothpaste. Both toothpastes contain fluoride and
have the American dental association seal of approval, but the high-quality
toothpaste tastes wonderful, and the low-quality toothpaste tastes horrible. The
costs of production are equal for both products. Toothpaste is an experience
good, so consumers cannot determine quality taste unless they buy the
toothpaste.
• WHICH OF THE TWO FIRMS HAS GREATER INCENTIVE TO
PROMOTE?

6.2. Welfare Implications of Advertisement 6.3. Technological Progress

 Optimal Advertising Invention, Innovation and diffusion
• Essentially negative advertisements reduce consumption. • What is the difference between invention and innovation?
• Firms, however, react to health warnings by increasing adverting.
• The lower the cost, the more advertising in a society. • Invention refers to the creation of a brand new product or device.
• Usually, firms with market power incur promotional expense to cause their • Concerned with Single product or process.
demand curves to shift out or become more inelastic, so they can sell more at higher
prices.
• innovation is an act of making changes to the existing product or the process
• However, it is possible for firms to advertise and still face very elastic demand by introducing new ways or ideas.
curves. • Concerned with Combination of various products and process.
• For example, such a firm may act as a price-taker, but needs to inform
customers where it is located.
• That is, advertising need not be inconsistent with price-taking behavior.
• Moreover, competing firms may jointly advertise to increase demand for a
homogenous product.
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6.4. Intellectual Property Right and the Incentive for Investment 6.4. Intellectual Property Right and the Incentive for Investment
in Technological Progress in Technological Progress
• Intellectual property rights are the rights given to persons over the (ii) Industrial property
creations of their minds. • The social purpose is to provide protection for the results of investment in
• They usually give the creator an exclusive right over the use of his/her the development of new technology, thus giving the incentive and means to
creation for a certain period of time. finance research and development activities.
• Intellectual property rights are customarily divided into two main areas:
(i) Copyright and rights related to copyright. • A functioning intellectual property regime should also facilitate the
transfer of technology in the form of foreign direct investment, joint ventures
• The main social purpose of protection of copyright and related rights is to and licensing.
encourage and reward creative work.
• Patents provide an inventor with exclusive rights to a new and useful
product, process, and substance or design.

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6.4. Intellectual Property Right and the Incentive for Investment
in Technological Progress
Incentives for Investment on Research and Development
• Most economists and policy markers believe that without patents or other
government incentives, there would be too little research.
• The chief reason is that inventions are fundamentally new information, and
information is public good.
• If someone possesses some information, you can possess and benefit from
that some piece of information.
• Thus, my knowledge of the information does not prevent you from using it. If some
consumers of the information can obtain it costless (for example, you can read a
book in a library). The producer of the information has less incentive to produce it
than, of every one had to pay for it.
• Why would one be willing to incur the entire expense of developing new
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information, processes, or products of people could benefit from them for free?
6.4. Intellectual Property Right and the Incentive for Investment
in Technological Progress
Incentives for Investment on Research and Development
• Although some people like inventors and firms under take research for the
pecuniary rewards.
• Thus, if they could not benefit from their new developments, this latter group
would not engage in research.
• Eliminating most such research would harm society because it has social
value.
• New manufacturing methods lower the costs of producing existing products
and allow society to produce more out put with the same amount of input.
• New products increased productivity (for example, improve seeds with higher
out put or better quality) or give pleasure.
• Therefore some form of protection should be given to intellectual
properties to encourage investment in them.
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• END OF CHAPTER SIX

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