ADVERTISING IN CUSTOMER MARKETS

AuthorHugh Sibly
DOIhttp://doi.org/10.1111/j.1467-9485.1995.tb01146.x
Publication Date01 Feb 1995
Sconish
lourno1
of
Political
Economy,
Vol.
42,
No.
I,
February
1995
0
Scottish
Economic
Society 1995.
Published by
Blackwell
Publishers.
108
Cowlcy
Road,
Oxford
OX4
IJF,
UK
and
238
Main
Sbut.
Cambridge,
MA
02142,
USA
ADVERTISING
IN
CUSTOMER MARKETS
Hugh
Sibly'
I
INTRODU~ON
The distinguishing characteristic of customer markets is the continuing
relationshtp between customers and retailers
(Okun,
1981 pp. 138-150).
Scitovsky (1952, 1978), and subsequently Parish (1966) and Stiglitz (1979), has
argued that such markets exhibit an information asymmetry. The information
asymmetry arises because repeat purchasing customers
are
informed of the price
set by their regular firm at each purchase. Customers who do not patronise the
firm are less frequently informed of its price. Scitovsky (1952, 1978) argues
that the information asymmetry gives rise to retail price stickiness. Subsequently
a number of authors have explored the implications of
this
price inflexibility
both at the macroeconomic and microeconomic levels (Ball and Romer, 1990;
Kling, 1982; McDonald, 1987, 1990a, 1990b; McDonald and Spindler, 1987;
McMillan and Morgan, 1988; Negishi, 1979;
Oh,
1981; Rowe, 1987; Sibly,
1992a and 1992c; Woglom 1982).
This
paper presents a two-period model of a customer market. It is similar in
approach to the continuous time models presented by McDonald (1990a,
1990b) and Sibly (1992a). These papers consider a firm's optimal pricing
response to a permanent demand
or
cost shock that occurs at a time which is
arbitrarily defined as time
0.
If the shock induces the firm to raise its price, all
customers who would not be willing to pay the new price under perfect
information will cease purchasing immediately. The firm thus moves up its
perfect-information demand curve. However, if the shock induces the firm to
lower its price, it cannot immediately move down its perfect-information
demand curve. Following a price decrease, there is a lag before all of the
potential new customers discover, either through active search' or passive
mechanisms such as word of mouth,' that price has been lowered. Thus
discounted marginal revenue
is
lower than would be the case under perfect
information. Consequently there is a discontinuity in the firm's discounted
'
However,
an
implication
of
the search model presented
in
Sibly (1992b)
is
that customers
will not undertake active, and costly, search under these conditions.
Thus
information is
transmitted only
through
passive mechanisms.
*The economic modelling
of
the word
of
mouth
mechanism was pioneered by Phelps and
Winter (1970).
'Department
of
Economics, University
of
Tasmania,
GPO
Box
252C, Hobart, Tas.,
7001,
Australia
66
ADVERTISING
IN
CUSTOMER MARKETS
67
marginal revenue
As
a result, there is a range of demand
or
marginal
cost that is consistent with a profit-maximising firm charging a given price.
Equivalently, there is a range of prices that are profit maximising, given a
particular level of demand and marginal cost.
The theory also has implications for the symmetry of price adjustment to
demand and cost shocks. Consider a shock to marginal cost which causes the
perfect-information monopoly price to
be
above the current price.
As
the firm
can move up its perfect-information demand curve, its optimal response to the
shock is
to
set price equal to the new perfect-information monopoly price. By
contrast, if a shock to marginal cost causes the perfect-information monopoly
price to be below the current price, the firm will never fully adjust price down to
the new perfect-information level. If the firm lowers price, as noted above,
discounted marginal revenue is lower than it would be under perfect infor-
mation. Thus, the price found by setting discounted marginal revenue equal to
discounted marginal cost is greater than the perfect-information monopoly
level.4 Consequently, customer market analysis predicts that there is an
asymmetry in price response to an upward and downward shock, in addition to a
range of equilibrium prices.
In
previous analyses of customer markets
it
has been assumed that a firm
could not influence the rate of flow of customers to it following a price fall.
In
this
paper
this
assumption is dropped and it is assumed that a firm may increase
the rate of flow of customers to it through advertising. The analysis presented in
Sibly (1992a) implies that, if the rate of customer flow following a price fall is
exogenously increased, then (i) the size of the range of equilibrium prices
decreases and (ii) the degree of pricing asymmetry decreases. Therefore it
might be thought that advertising, by increasing the rate of customer flow
following a price decrease, could reduce or eliminate both the stickiness and the
asymmetric response of price to permanent shocks.
This
paper addresses
this
issue by incorporating advertising into a model of the type presented in
McDonald (1990a, 1990b) and Sibly (1992a). It is demonstrated that, although
the introduction of advertising might reduce the stickiness and the asymmetric
response of price to permanent shocks, these effects are not eliminated unless
advertising is costless.
The treatment of advertising presented in
this
paper differs from the classic
treatments of advertising (Dorfman and Steiner, 1954; Schmalensee, 1972;
Nerlove and Arrow, 1962) as it does not shift a firm’s perfect-information
demand curve. Similarly, advertising does not change tastes (as in Stigler and
Becker, 1977; Nichols, 1985). Rather, as in Butters (1977), Grossman and
Parish (1966) and Stiglitz (1979) stress that the kinked demand curve discussed here arises
for
entirely different reasons to those given for a kinked demand curve in oligopoly theory.
Parish argues that
this
theory, introduced by Sweezy (1939). ‘rests
on
an
essentially arbitrary
assumption concerning oligopolists beliefs about their rivals’ behaviour’. By contrast, the kink
in a firm’s demand curve discussed
in
this paper arises because there is
an
information
asymmetry amongst customers.
‘Sibly (1992a) demonstrates, by modelling the
firm’s
pricing decision as a dynamic
programming problem, that following the initial fall in price it is optimal for the firm
to
maintain a constant price over time.
0
Scottish
Economic
Society
1995

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