Advertising and Collusion in Retails Markets

Kyle Bagwell, Gea M. Lee
JEL codes: 
Paper No. 08-2008

We consider non-price advertising by retail firms that are privately informed as to their respective production costs. We first analyze a static model. We construct an advertising equilibrium, in which informed consumers use an advertising search rule whereby they buy from the highest-advertising firm. Consumers are rational in using the advertising search rule, since the lowest-cost firm advertises the most and also selects the lowest price. Even though the advertising equilibrium facilitates productive efficiency, we establish conditions under which firms enjoy higher expected profit when advertising is banned. Consumer welfare falls in this case, however. We next analyze a dynamic model in which privately informed firms interact repeatedly. In this setting, firms may achieve a collusive equilibrium in which they limit the use of advertising, and we establish conditions under which optimal collusion entails pooling at zero advertising. More generally, full or partial pooling is observed in optimal collusion. In summary, non-price advertising can promote product efficiency and raise consumer welfare; however, firms often have incentive to diminish advertising competition, whether through regulatory restrictions or collusion.