Informative advertising is most desirable when products are differentiated and
consumers find it difficult to select the ones that best fit their preferences.
This chapter summarizes only the effects of advertising on product
differentiation. Products are said to be "vertically differentiated" if all
consumers agree on which product is better. If two products differ in terms of
quality, for example, all consumers will want a higher quality product if the
two products are priced the same. If two products have the same quality but
differ only in color, however, some consumers will prefer red whereas others
will prefer blue even when the prices are the same. The latter is a case of
horizontal product differentiation.
For horizontally differentiated products, informative advertising enables a
consumer to find a product that best matches his or her preference. A
consumer's preferences can be graphed as locations in a spatial market or city.
The distance between the locations of a firm and a consumer represents the
difference between a product and the consumer's preference. Therefore, an
advertisement about a product's location helps the
consumer find out which product is closer to one's location.
The obvious incentives for firms to convey product information to consumers
are the increase in sales and the reduced demand elasticity due to consumers'
knowledge that competing products do not offer a better match.
After consumers find their match, advertising builds brand loyalty and
increases the firm's market power. Also, a firm's advertising is bound to inform some consumers that its product does not match their tastes. In a simplified
market with two firms, one firm's advertising is beneficial to its competitor— a
type of public good have also shown that informative advertising actually
reduces price competition among firms; thus consumer welfare is lowered despite
a better preference-product matching. The loss to consumers is due to a higher price;
as a result, there is an incentive for firms to provide excessive informative
Does advertising affect product differentiation itself? In some cases,
advertising can result in spurious product differentiation by which consumers
are persuaded to think, albeit mistakenly, that there are differences in
competing products. Many over-the-counter drugs and household chemicals
have essentially the same ingredients but consumers perceive them to be
different largely because of advertising.
When products are vertically differentiated (for example, by quality), truthful
advertising may solve the lemons problem discussed in Chapter 4 by signaling
quality. If all customers are informed about product quality, a high- quality good
should command a higher price than a low-quality good. If advertising is
truthful and credible, higher price means higher quality.