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This paper examines the welfare implications of informative advertising in differentiated product oligopoly markets. The analysis reconciles the conflicting results in previous studies that find advertising to be undersupplied in homogeneous product markets, but oversupplied in differentiated product markets when the degree of differentiation is “small”. In equilibrium, purely informative advertising is undersupplied when brands are sufficiently close substitutes and oversupplied when brands are more differentiated. Product differentiation also has welfare implications for the effect of technological change in the advertising sector. In response to an advertising cost innovation, equilibrium prices fall and the market converges to the socially optimal resource allocation for brands that are sufficiently close substitutes, whereas equilibrium prices rise and divergence occurs when brands are more differentiated.

An important role of advertising is to provide consumers with factual information about product attributes. Advertising that informs consumers about product specifications benefits society both by stimulating the exchange of products to new customers and by facilitating better matches between existing customers and brands. But advertising is also a costly activity, for instance annual advertising expenditures in the U.S. represent approximately 2.3% of GDP (Advertising Age), and delivering informative advertisements to consumers who are already informed about products is a socially wasteful activity. This paper addresses the efficiency of informative advertising outcomes in oligopoly markets. Social and private advertising incentives differ in the model due to three external effects, the relative importance of which depends on how the value of information is capitalized among “new” and “existing” customers in the market. Informative advertising that reaches new consumers embodies an externality familiar to search goods: The cost of search is borne entirely by the searcher, while the benefits are divided between the searcher and the agent with whom she trades. This market size effect causes advertising to be undersupplied in the market equilibrium. Informative advertising that reaches existing consumers of a rival brand potentially improves the matches between consumers and brands, thereby raising consumer utility. Because advertising firms are unable to fully appropriate these rents, this matching effect also causes advertising to be undersupplied in the market equilibrium. But informative advertising by one brand that reaches existing consumers of a rival brand also serves to attract customers away from rivals, an activity that is less valuable to society than to individual firms. This business-stealing effect causes advertising to be oversupplied in the market equilibrium.

This paper has considered a model of purely informative advertising with differentiated products. Advertising informs consumers about prices and the attributes of products, and doing so improves the matches between consumers and brands. Relative to the social optimum, advertising levels in the market equilibrium were shown to be too low when the competing brands are highly substitutable, too high when the brands are moderately differentiated, and too low again when the brands are highly differentiated. Advertising cost innovations that improve the delivery of ads (expenditure given) have disparate affects on welfare that depend on the degree of product differentiation in the market. At low levels of product differentiation, a decrease in advertising costs causes equilibrium prices and advertising levels to converge towards the socially optimal levels, whereas divergence occurs at higher levels of product differentiation. A number of empirical studies have found advertising to create both market size effects and to alter the market shares of firms. For example, Roberts and Samuelson (1988) find cigarette advertising increased total market demand without a significant influence on market shares, while Nelson (1999) finds advertisements for beer, wine and distilled spirits altered market shares among advertised brands without an appreciable affect on market demand. The present model highlights the importance of isolating these effects in empirical studies of advertising. In industrial settings where advertising produces negligible effects on market size, advertising is more likely to be oversupplied and technological innovations that reduce advertising costs can lead to a deterioration of market performance.