[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

remains the same, so the second source of extra profits is the shaded area EFG.
The net increase in profits is the area ABCD plus the area EFG minus the cost
of advertising.
So far, in studying the effect of an increase in advertising on one firm’s profits,
we have assumed that other firms keep their level of advertising constant.
Determining the effect of advertising on both industry and firm profits is more problematic
once the reactions of other firms in the industry are taken into account. To
the extent that advertising diverts sales from one firm in an industry to another, it
may, in equilibrium, have little effect on demand. For example, assume that Nike
shoe ads divert customers from Reebok to Nike and vice versa for Reebok ads. Figure
15.3 shows the demand curve facing Reebok (1) before advertising, (2) when only
Reebok advertises, and (3) when both companies advertise. The third demand curve
is the same as the first. Price and output are the same; profits are lower by the
amount spent on advertising. We have here another example of a prisoner’s dilemma.
If the firms could cooperate and agree not to advertise, they would both be better off.
But without such cooperation, it pays each to advertise, regardless of what the rival
does. The government-mandated ban on cigarette advertising on radio and TV may
have partially solved this prisoner’s dilemma for the tobacco industry—in the name
of health policy.
In practice, when all cigarette firms advertise, the ads do more than just cancel
each other out. Some people who might not otherwise have smoked are persuaded
to do so, and some smokers are persuaded to smoke more than they otherwise would
have. But the shift in a particular firm’s demand curve when all companies advertise
is still much smaller than it is when only that firm advertises.
PRICE
Demand curve:
no advertising or
both advertise
Figure 15.3
QUANTITY
Demand curve:
only Reebok
advertises
HOW ADVERTISING CAN
CANCEL OUT OTHER
ADVERTISING
If only one company advertises, the
demand curve for its product may shift
out. But if both companies advertise, the
resulting demand curve may be the same
as it would be if neither advertised.
Wrap-Up
CONSEQUENCES OF IMPERFECT
INFORMATION
In the presence of adverse selection problems, quality may be affected by price.
Adverse selection can lead to thin markets or the failure of markets to even exist.
Signaling plays an important role in adverse selection problems.
In the presence of weak or misdirected incentives, moral hazard problems arise.
Contingent contracts and reputation are important solutions for incentive
problems.
In the presence of price dispersion, consumers must engage in search.
Because searching is costly, firms face downward-sloping demand curves and
competition is imperfect.
In the presence of imperfect information, firms engage in advertising.
Advertising can be used to change perceptions of product differences, altering
the slope of the demand curve.
Advertising can be used to shift the demand curve.
ADVERTISING ∂ 349