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Analysis of the welfare effect of advertising depends critically upon the effect of advertising on market prices. In many circumstances, advertising that leads to higher (lower) market prices is overproduced (underproduced) from society’s perspective. This paper demonstrates that these predictions may not hold when consumer search costs are important. A model is developed to show how advertising affects equilibrium prices, search costs, and social welfare in monopoly and imperfectly competitive markets. When informative advertising leads to a sufficient reduction in consumer search costs, both consumer and producer welfare may increase even though market prices rise. This conclusion has important implications for policy analysts, because it demonstrates that one cannot test the welfare effect of advertising by determining the impact of advertising on market prices alone. One must investigate the impact of advertising on both market prices and search costs to fully understand the welfare effect of advertising.

Debate about the social desirability of advertising has a long history and is characterized by very polarized positions. In the economics literature, Chamberlin (1933, pp. 119–120) argues that advertising may increase demand “by altering wants themselves”. This is a manipulative form of advertising as it exploits “the laws of psychology” with which the consumer “is unfamiliar and, therefore, against which he cannot defend himself…” McFadden and Train (1996) define this as a form of persuasive advertising that changes consumer tastes or beliefs about the product without changing the actual product characteristics themselves. In their classic work, Dixit and Norman (1978) argue effectively that when advertising changes tastes, any resulting increase in consumer surplus is illusionary and, therefore, should not be included in welfare calculations.1 Of course, not all forms of advertising are detrimental to society. Stigler, 1961 and Telser, 1964 contend that advertising can provide useful information, which leads consumers to lower priced products with more preferred characteristics. In addition, Nelson, 1974 and Milgrom and Roberts, 1986 show that advertising can signal quality in markets for search goods. More recent research has investigated how specific types of advertising affect market equilibria. For example, Stahl, 1994 and Bester and Petrakis, 1995 identify conditions under which firms in an oligopoly setting choose pure and mixed strategies in price and advertising. Regarding informative advertising, Stegman, 1991, Hernandez-Garcia, 1997 and LeBlanc, 1998 investigate the impact of informative advertising when firms advertise in several media, use targeted advertising, and use advertising that reaches all consumers at a fixed cost. For purely persuasive advertising, Von der Fehr and Stevik, 1998, Bloch and Manceau, 1999, Tremblay and Martins-Filho, 2001 and Tremblay and Polasky, 2002 determine the effect on market prices of advertising that changes consumer perceptions about horizontal and vertical product differentiation.

The welfare effect of advertising is complicated in markets where consumer search costs are important. When advertising is primarily persuasive and has no effect on search costs, our work confirms previous results that advertising will be oversupplied in the marketplace when it leads to higher market prices. This result need not hold, however, when advertising lowers consumer search costs. Under a reasonable set of conditions, advertising that raises market prices need not be oversupplied from society’s perspective as long as it leads to a sufficient reduction in search costs. The two important conditions that must hold are consistent with many real world markets. The first is that advertising cannot lower consumer utility directly. This condition is met when advertising’s function is to lower consumer search costs. The second is that the market must be uncovered. That is, advertising must attract new consumers and, therefore, increase market demand. There are numerous examples where informative advertising increased market demand, especially for commodities where consumer information about product characteristics is low. For example, Tennant (1950) finds that advertising attracted new cigarette smokers in the early development of the industry (1914–1940). More recently, informative advertising by the producers of the new drug Strattera has increased awareness of adult attention deficit disorder (adult ADD) and has led to an increase in the market demand for drugs that treat this disorder (Szegedy-Maszak, 2004). In new markets where consumer search costs are high, it is reasonable to assume that informative advertising lowers consumer search costs and increases market demand.