Underestimating Advertising: Innovation and Unpriced Entertainment

By Nakamura, Leonard | Business Review (Federal Reserve Bank of Philadelphia), Winter 2005 | Go to article overview

Underestimating Advertising: Innovation and Unpriced Entertainment


Nakamura, Leonard, Business Review (Federal Reserve Bank of Philadelphia)


Although advertising is often the object of much disrespect, it nonetheless plays a significant role in the economy. For one thing, it helps consumers find out about new products, and new products have been rising in economic importance. Therefore, this relationship between new products and advertising makes it worthwhile to revisit the economics of advertising. In this article, Len Nakamura discusses advertising's role as a productive economic activity as well as its value as a long-term investment and its role in subsidizing entertainment, such as TV and radio broadcasts.

It's easy to disrespect advertising. Ads interrupt football games, impede news reports, and slow Internet searches. It should be no surprise, then, if the social usefulness of advertising is underestimated. Even economists, usually so mindful of the benefits of free markets, have often been unaware of the multiple benefits advertising provides.

Consider its role in new product development, the source of so much economic progress. If potential users don't find out about new products so that they can buy them, firms will have little incentive to create them. That's where advertising comes in: It helps consumers learn more quickly about the existence and properties of new products, so they can buy them, thereby making themselves, as well as the firms that made the products, better off.

Advertising thus helps firms and users benefit more from creativity. Larger returns increase the expected rewards to creativity, encouraging new product development and productivity gains. Since new products have been rising in economic importance, this nexus between new products and advertising makes it worthwhile to revisit the economics of advertising. Advertising--although widely disrespected--can be an unusually productive economic activity. Two other aspects of advertising are often overlooked: its value as a long-term investment and its role in subsidizing entertainment such as TV and radio broadcasts.

ADVERTISING: HOW IT WORKS AND HOW WE VIEW IT

Advertising has been derided as being, on its face, a creator of wasteful monopoly. In this view, advertising creates an artificial monopoly that, in turn, compensates the maker of the advertised product for the expense of advertising. Consumers would be better off without advertising. The additional price paid for the advertised product may waste economic resources if it does nothing to enhance the product. The British economist Nicholas Kaldor worried about this aspect of advertising in his seminal article. Can advertising do anything to enhance a product? It is only words and images, smoke and mirrors.

Advertising Reduces Search Costs. Is it so obvious that words really do nothing? Perhaps advertising makes a product more valuable to consumers. To see how it can do so, we begin by recognizing that advertising is a form of communication, of transmitting information. The systematic study of information transmission dates from University of Chicago economist George Stigler's classic 1961 article on information. In that article, he directly addressed advertising, arguing that it can be defined as communicating with consumers about products.

Stigler focused on the simple case of consumers who know a product exists but not where to buy it, and who might have to expend time and energy to locate it. In this case, advertising that lets consumers know where to buy a product (or its price) can lower the consumers' search costs. A bird in hand being worth more than one in the bush, advertising raises the price a consumer will pay at a given location.

Advertising New Products.

Another type of informative advertising tells consumers about the qualities of new products. New products are protected from competition by patents and copyrights, but these protections do not inform consumers about the existence of the new products and their attributes. This is the job of advertising; advertising helps consumers adopt new products faster, speeding profits for the new product's developers. …

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