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I consider an oligopoly model where, prior to price competition, firms invest in persuasive advertising and induce brand loyalty in consumers who would otherwise buy the cheapest alternative on the market. This setting, in which persuasive advertising is introduced to homogeneous product markets, provides an alternative explanation for price dispersion phenomena. Despite ex ante symmetry, the equilibrium profile of advertising outlays is asymmetric. It follows that endogenously determined brand loyal consumer bases are not symmetric across firms. This raises a robustness question regarding Varian's “model of sales” where symmetry is exogenously assumed.

Significant amounts of money are spent every year on advertising. The largest 100 advertisers in the US laid out a total of USD 90.31 billion on advertising in 2003 (see Advertising Age, June 28, 2004). Noticeably, in many advertising-intensive markets the products are nearly homogeneous. This suggests that advertising could be used to redistribute buyers amongst sellers and not (only) to increase demand. Scherer and Ross (1990) note: “[d]ouble-blind experiments have repeatedly demonstrated that consumers cannot consistently distinguish premium from popular-priced beer brands, but exhibit definite preferences for the premium brands when labels are affixed-correctly or not.” Although a vast literature spans the economics of advertising(see Bagwell, 2007), there are only a few theoretical models of persuasive advertising in nondifferentiated good markets. This article models homogeneous product markets where persuasive advertising creates subjective product differentiation and changes the nature of subsequent price competition. In particular, it studies the strategic effect of persuasive advertising in a two-stage oligopoly model where firms compete in non-price advertising and prices. Advertising induces brand loyalty in consumers who would otherwise purchase the cheapest alternative on the market. Firms first invest in advertising, and then compete in prices for the remaining brand indifferent consumers. Despite a priori symmetry of the firms, the advertising levels chosen by the firms are asymmetric in all subgame perfect equilibria of the two-stage game. One firm chooses a lower advertising level, while the other firms choose the same, higher level. In all pricing equilibria, at least two firms randomize on prices. The low advertiser prices more aggressively than the heavy advertisers in expected terms. The firms counterbalance their advertising and pricing decisions. A related strand of literature deals with price dispersion phenomena in homogeneous product markets.1 Varian (1980) constructs a “model of sales” where coexistence of fully informed and uninformed consumers results in equilibrium price dispersion. The uninformed (captured) consumers are evenly distributed across firms. The pricing stage in the current model is a modification of the model of sales, with asymmetric bases of captured consumers. In a variant of the model of sales, Rosenthal (1980) observes the existence of asymmetric pricing equilibria with at least two firms randomizing. Baye et al. (1992) fully characterize the asymmetric equilibria in the symmetric model of Varian. The current model builds up on a generalization of these results to asymmetric consumer bases. The two-stage game considered offers a way of endogenizing consumers’ heterogeneity. It turns out that the symmetric outcome does not obtain, raising a robustness question regarding Varian’s (1980) symmetric model.

The present article proposes a way to model the effects of persuasive advertising on price competition in a homogeneous product market. In a two stage game, an oligopoly first invests in persuasive advertising and, then, competes in prices. Advertising results in the creation of loyal consumer groups attached to the firms. The model predicts asymmetric advertising outlays despite the initial symmetry of the firms. This finding matches the empirical evidence in advertising intensive markets. The setting shows how persuasive advertising may be used to relax price competition, and links it to equilibrium price dispersion.