29/05/2007
Measuring the Accountability of Advertising Expenses in the Presence of Sales Cost Inefficiency and Marketing Spillovers

Measuring the Accountability of Advertising Expenses in the Presence of Sales Cost Inefficiency and Marketing Spillovers

This paper develops a tractable theoretical framework for analyzing the substitutability between different advertising media, the extent of marketing spillovers in the market, the allocative efficiency of advertising spending, and the sources of total advertising productivity and sales growth.

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Advertising (persuasive or informative) is a critical element of business conduct affecting consumer valuation of advertised goods, market structure, firm profitability and social welfare. It requires significant resources as well as skills in determining the appropriate messages and the media used to communicate them. It has received considerable attention in the economic literature with the main focus being either on the market and welfare effect of different advertising strategies or on empirically estimating structural models (i.e., sales or advertising cost function) aimed to characterize marketing technology and the effectiveness of marketing efforts. This strand of advertising literature, using structural models, has been based on the separability assumption between marketing and production technologies initiated by Brown (1978), Waterson (1984) and Brensahan (1984). In these empirical models three important issues have been considered so far: first, the substitutability of advertising media (e.g., Seldon and Jung, 1993; McCullough and Waldon, 1998; Seldon et al., 2000; Silk et al., 2002); second, the role of scale economies in advertising (e.g., Seldon et al., 2000); and third, the degree of advertising efficiency (e.g., Luo and Donthu, 2001; 2005; Fare et al., 2004; Vardanyan and Tremblay, 2006).

The interest in media substitutability and the role of returns to scale stems from the question regarding three separate public policy debates: first, the effectiveness of partial advertising media bans; second, the effects of merger wave among radio, television and printed media firms and; third, the anticompetitive effects of advertising. Firms banned from using one advertising medium could maintain a constant level of sales by increasing their use of another advertising medium if the latter is substitutable for the former. As a result, intermedia substitutability tends to limit the effectiveness of partial advertising bans but complementary relations may also be expected since firms often use more than one class of media in a given campaign (Silk et al., 2002). All these are about the flexibility of advertising mix in attaining a given level of sales.

On the other hand, the recent merger wave among entertainment corporations worldwide raises important concerns with regard to the market power accrue to the owners of merged broadcasting and printed media firms that sell advertising spots (Slade, 1998; Busse and Rysman, 2005). Competitive pricing of advertising outlets (i.e., TV, radio, printed media) is ensured by easy of substitution between advertising media. If, however, broadcasting or printed media firms are merged, then the easiness of media substitutability across markets, will result in increased advertising spot prices and therefore in detetorating consumer’s welfare. Apart of that, advertising expenses are considered as a key determinant of the barriers to entry in a market and, therefore, an important determinant of market structure. Comanor and Wilson (1969) were among the first to argue that advertising affects the height of barriers to entry through the existence of scale economies. In the presence of such economies, potential entrants face an additional (sunk) capital requirement, which can deter entry and therefore decrease competition in the market. While the determination of effective marketing campaigns (i.e., strategies that can achieve certain firm objectives) is certainly necessary for the successful performance of a firm, such a determination is not sufficient – a key issue is the identification of those effective advertising campaigns that are also efficient, i.e., they can achieve the firm objectives at minimum cost. High levels of advertising inefficiency, plagues business and frustrates managers as inefficient advertising spending and misallocated resources results in lower profit margins and obstacle firm’s sustainable growth. Several authors recently considered that advertising expenses might not be as efficient as it has been recognized in generating sales (e.g., Smith and Park, 1992; Luo and Donthu, 2001, 2005; Färe et al., 2004; Vardanyan and Tremblay, 2006).

Technical efficiency of advertising is certainly important, but it is not the sole determinant of advertising efficiency. Another but closely related issue that has not been considered previously is on whether the choice in advertising mix is in accordance with the observed prices for messages in the various media types, in firms’ attempts to attain a given level of sales with the minimum possible cost. This is about allocative inefficiency in advertising and how it may affect competitiveness by increasing unnecessarily the cost of advertising compared to rival firms. With the benefits of advertising varying between different advertising media (Becker and Murphy, 1983; Tirole, 1988; Yiannaka et al., 2002; Färe et al., 2004),2 the identification of the allocative efficient advertising mix can be a challenging proposition. Nerlove and Arrow (1962) and Grabowski (1970) argued that while the advertising to sales ratio varies across firms and industries, individual firms tend to allocate a nearly fixed ratio over time which, in turn, suggests that firms may be engaged in a “rule of thumb” decision making when faced with uncertainties regarding the allocation of advertising expenses. This is particularly true in highly protected sectors and oligopolistic markets where government intervention and imperfect competition create major impediments to the efficient allocation of resources (Fulginiti and Perrin, 1993).

However, media allocation is a critical dimension of advertising decision making, and it has even been suggested that it is more important than advertising spending decisions (Doyle and Saunders, 1990). Our study also attempts to complement existing literature by offering an evaluative tool for a brand's budget allocation decisions over time. As suggested by past studies, different media may exhibit different long-term effectiveness, suggesting that budget allocation plans have long-term implications. However, marketing efforts in practice are often driven by short-term profit maximization goals or by competitive reactions (Dekimpe and Hanssens, 1995; Yoo and Mandhachitara, 2003). As a result, budget allocation decisions may not be formulated based on their long-term potential. Allocative is one of the components of cost inefficiency considered by Luo and Donhu (2001, 2005), Färe et al., (2004) and Vardanyan and Tremblay (2006), and it indicates how correctly firms are able to transmit prices signals into their input choices. One of the contributions of the present paper is to bring allocative inefficiency explicitly in the empirical analysis of the advertising process by examining its relative importance compared to technical inefficiency.

The second contribution is to empirically quantify the advertising spillovers among firms, that is, the effect of the marketing efforts of one firm on the marketing effectiveness of other firms within the same market (Metwally, 1975; Friedman, 1983; Sheldon et al., 2000; Yiannaka et al., 2002; Bagwell, 2005).3 Empirical studies reveal that advertising spillovers are significant particularly in markets where non-cooperative behavior occurs between firms (e.g., Tremblay and Polasky, 2001). The magnitude and the direction of these spillovers depend on the extent to which competing products are homogeneous with similar characteristics, the stage of market development and the kind of advertising message. On the other hand, advertising spillovers are unlikely to be significant in markets where products have very different characteristics and where consumers have a strong loyalty to a particular brand (Ackerberg, 2001).4 In addition, advertising spillovers are not present in a monopoly market or in market where producers cooperate in their marketing efforts (Liu and Forker, 1988). However, in cases that firms are producing a homogeneous product advertising spillovers are present and affecting the demand for all brands and at the same time individual advertising expenses. The former is the sales effect of advertising spillovers associated with the changes in individual firm sales, whereas the latter is the generic effect related with the changes in individual advertising expenses. These spillovers may well be affected by the extent of advertising messages in each particular market. This crowding-out effect may affect both positive or negative individual marketing expenses. For instance in markets with homogeneous products, if firms are not cooperating and heavily advertise their products, the effect of spillovers may turn to be negative due to high levels of advertising expenses undertaken by rivals which increase the cost of promotion. Finally, the spillover effect may also depend on the maturity stage of the market (maturity effect). In later stages, when the market matured, advertising may become predatory creating negative spillovers.5 The net spillover effect is case specific and depends on the direction of each one of these four different effects.

The third contribution of the present paper is to relate allocative inefficiency and advertising spillovers with the previously analyzed issues of scale economies and cost inefficiency in order to provide a more comprehensive picture of performance evaluation based on the notion of total advertising productivity (TAP) growth. Recently, Rust et al., (2004) pinpoint concerns about the productivity of advertising and sales promotion expenditures. In particular, to rebuild confidence in advertising and marketing investment, they suggest the urgent need to “show how marketing adds to shareholder value, as the perceived lack of accountability has undermined marketing’s credibility, threatened marketing’s standing in the firm, and even threatened marketing’s existence as a distinct capability within the firm”. For the advertising process TAP refers to the increase in sales that cannot be accounted by the observed increase in the number of advertising messages in various media. It may be due to changes in advertising technology per se, to scale economies in advertising, to improvements in technical and allocative efficiency and, to the net advertising spillover effects. The empirical question is to estimate the relative importance of each of these sources of sales growth and then to use this information to propose appropriate measures for improving advertising effectiveness.

The objective of this paper is to address these issues developing a tractable approach for analyzing empirically the marketing process and advertising effectiveness Maintaining the separability assumption between sales and production technology, the proposed approach relies on the theoretical framework developed by Karagiannis et al., (2004) which is adapted in an advertising cost function setting. Utilizing a flexible advertising distance function, the developed methodology is then applied to the advertising activity of meat processing firms in Greece during the period 1983-1997. 

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