Zwick Center for Food and Resource Policy

We introduce a model of dynamic price and advertising competition and use the model to investigate a popular segment of the Ready-To-Eat Cereal Market. It is well understood that advertising is a key non-price strategic demand determinant in differentiated product markets. Two popular and compatible models for the role of advertising have emerged. One model specifies advertising as a determinant of a consumer’s level of product awareness (informative) and the other model specifies advertising as a complimentary product attribute (persuasive). Without specific information on a consumer’s level of awareness the two roles cannot be simultaneously identified within a demand model. One must then decide how advertising enters the demand model. To explore the implications of this specification decision on the assessment of price and advertising competition we: Estimate heterogeneous consumer logit demand models for each advertising specification; define a model of price and advertising competition for multi-product firms; and compute the distribution of equilibrium price and advertising strategies to asses the fit against the observed price and advertising strategies. To illustrate how the market model may be applied we investigate a segment of the ready-to-eat cereal market and evaluate a hypothetical brand acquisition. The analysis provides three key empirical findings: Upward pricing pressure, due to the acquisition, is larger when advertising is incorporated into the demand model as a result of estimation bias; the informative advertising model yields downward pressure on price while the persuasive advertising model yields upward pressure on price; and the information theoretic model fits the data better.