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Advertising and Coordination

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  • Kyle Bagwell
  • Garey Ramey

Abstract

We show that when relevant market information such as price is difficult to communicate, advertising plays a key role in bringing about optimal coordination of purchase behavior: an efficient firm uses advertising expenditures in place of price to inform sophisticated consumers that it offers a better deal. This provides a theoretical explanation for Benham's (1972) empirical association of the ability to advertise with lower prices and larger scale. We find that advertising improves welfare unambiguously when firms' price choices are the only source of uncertainty. When advertising must also signal the identity of the efficient firm, however, a welfare tradeoff arises between advertising and coordination. Our results extend readily to situations of partial price observability and product quality uncertainty.

Suggested Citation

  • Kyle Bagwell & Garey Ramey, 1990. "Advertising and Coordination," Discussion Papers 903, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    • Handle: RePEc:nwu:cmsems:903
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    References listed on IDEAS

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    1. Kihlstrom, Richard E & Riordan, Michael H, 1984. "Advertising as a Signal," Journal of Political Economy, University of Chicago Press, vol. 92(3), pages 427-450, June.
    2. Kyle Bagwell & Garey Ramey, 1991. "Oligopoly Limit Pricing," RAND Journal of Economics, The RAND Corporation, vol. 22(2), pages 155-172, Summer.
    3. Benham, Lee, 1972. "The Effect of Advertising on the Price of Eyeglasses," Journal of Law and Economics, University of Chicago Press, vol. 15(2), pages 337-352, October.
    4. Milgrom, Paul & Roberts, John, 1986. "Price and Advertising Signals of Product Quality," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 796-821, August.
    5. Katz, Michael L & Shapiro, Carl, 1986. "Technology Adoption in the Presence of Network Externalities," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 822-841, August.
    6. Kyle Bagwell, 1987. "Introductory Price as a Signal of Cost in a Model of Repeat Business," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 54(3), pages 365-384.
    7. Steven A Matthews & Doron Fertig, 1990. "Advertising Signals of Product Quality," Discussion Papers 881, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    8. In-Koo Cho & David M. Kreps, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 102(2), pages 179-221.
    9. Nelson, Phillip, 1970. "Information and Consumer Behavior," Journal of Political Economy, University of Chicago Press, vol. 78(2), pages 311-329, March-Apr.
    10. Kyle Bagwell & Garey Ramey, 1996. "Capacity, Entry, and Forward Induction," RAND Journal of Economics, The RAND Corporation, vol. 27(4), pages 660-680, Winter.
    11. Cady, John F, 1976. "An Estimate of the Price Effects of Restrictions on Drug Price Advertising," Economic Inquiry, Western Economic Association International, vol. 14(4), pages 493-510, December.
    12. George J. Stigler, 1961. "The Economics of Information," Journal of Political Economy, University of Chicago Press, vol. 69(3), pages 213-213.
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