“ Pricing and Persuasive Advertising in a Differentiated Market”

We examine how competitive firms’ pricing and persuasive advertising strategies as well as profits are affected by changes in consumer preferences, unit production costs, and advertising efficiencies. We highlight three interesting findings from our analyses. First, when firms make endogenous advertising decisions in addition to pricing, a seemingly favorable exogenous shock to one firm alone may lead to a lower equilibrium profit for that firm and a higher profit for its competitor. Second, firms’ advertising depends on the degree of product differentiation and firms’ optimal advertising responses to an exogenous change are opposite—one firm increases advertising whereas the other reduces it. The firm receiving a favorable shock in product valuation is likely to complement it with additional advertising, especially when advertising is inefficient or expensive. Third, an exogenous shock may reduce the price dispersion in the industry even though it increases the separation between the firms’ valuations or perceived qualities. Our results are robust to alternative game structures, heterogeneity in consumer response or exposure to advertising, nonlinearity of consumer taste preferences, and alternative functional forms for advertising costs.