Answers to Chapter 14 Exercises

Review and practice exercises

14.1. IBM mainframes. Empirical evidence suggests that, during the 1970s, a firm
with an IBM 1400 was as likely as any other firm to purchase an IBM when making a new
purchase, while a firm with an IBM 360 was more likely to purchase an IBM than a firm
that did not own an IBM 360. Software for the IBM 1400 could not run on the succeeding
generations of IBM models (360, 370, 3000, and 4300), while software for the IBM 360 could
run on the 370, 3000 and 4300.17 How do you interpret these results?
Answer: These results suggest how backwards compatibility influences the degree of switch-
ing cost. Switching away from an IBM 1400 was less costly because there was no backwards
compatibility between later models and the software developed for the IBM 1400. The same
was not thue for the 360,370, 3000 and 4300 models. Consumers who bought one of these
models had a higher opportunity cost of switching to a non-IBM computer. As we would
expect, these consumers were more likely to buy IBM in the future than other consumers.

14.2. Price dispersion. “Price dispersion is a manifestation — and indeed it is a measure

— of ignorance in the market.”18 Do you agree? Compare this explanations with possible
alternative explanations for price dispersion.
Answer: If we consider search costs as being a measure of market ignorance, then indeed the
above claim holds. As in note f) in section 12.4, quotation of prices in di↵erent currencies
makes comparison shopping more difficult by increasing “search costs”. The fact that buyers
do not know or bother to learn how to transform prices from one currency into another is
a sign of ignorance, which supports price dispersion.
Other alternative explanations for price dispersion may be: price discrimination, dif-
ferent regulatory or taxation regimes (geographical price dispersion) or di↵erent shopping
experience (see the example for CDs bought in a small music shop or in a supermarket).

14.3. Uninformative advertising and market efficiency. Explain how advertising ex-
penditures with no direct informational content can increase market efficiency.
Answer: As discussed in Section 14.3, advertising expenditures may signal product quality.
In the presence of repeat purchases, a firm that produces a high-quality good and sells the
good not only in the present but also in the future, will have more to gain from getting
customers to try its product than a firm that produces a low-quality good. This is because
once a good is purchased, consumers become aware of its quality; and if it’s high, they
will repeat the purchase in future periods. If, however, a consumer does not get to try the
good in the present, in the future he or she will still be uncertain about the good’s quality.
Therefore, high-quality goods producers will try to lure customers in the present since their
gain is higher. They thus have an incentive to di↵erentiate themselves from low-quality
goods producers.
Although advertising has no direct informational content, the equilibrium with adver-
tising may be more efficient than the equilibrium without advertising. Absent advertising,
high-quality firms have no incentive to produce, since they cannot di↵erentiate themselves;
their products are ex-ante identical to the ones produced by low-quality firms. Therefore,
if consumers value high-quality goods, even if there are savings in advertising expenditures,
the overall efficiency e↵ect may be negative, due to the loss in the availability of high-quality
goods.

14.4. Advertising and brand switching. Empirical evidence suggests that the proba-
bility of a household switching to a di↵erent brand of breakfast cereal is increasing in the
advertising intensity of that brand. However, the e↵ect of advertising is significantly lower
for households who have previously tried that brand.19 What does this suggest about the
nature of advertising expenditures (persuasion vs information)?
Answer: The evidence is consistent with advertising having an informative role: consumers
who are already experienced with the good are therefore less sensitive because they require
no additional information. Notice this is consistent with advertising not having any infor-
mative content. As shown in Section 14.3, advertising may be a signal of product quality;
this type of advertising leads consumers to experience a good and thus be informed about its
characteristics. As a result, even though advertising does not convey any hard information
about product characteristics, indirectly it leads consumers to become informed.

14.5. Advertising intensity. Consider the following industries: pharmaceuticals, cement,

perfumes, fast food, compact cars. How would you expect them to be ordered by advertising
intensity? Why?
Answer: According to the Equation (14.6), advertising intensity is proportional to the de-
mand elasticity of advertising expenditures and inversely proportional to the price elasticity
of demand. Price elasticity of demand is lowest for pharmaceuticals and perfumes, highest
for cement. Advertising elasticity is lowest for cement, highest for perfumes (and some
pharmaceuticals). We would expect advertising intensity to be highest for pharmaceuticals
and perfumes, lowest for cement, intermediate for fast food and compact cars.

Challenging exercises

14.6. Product positioning and price competition. Consider a duopoly where horizon-

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tal product di↵erentiation is important. Firms first simultaneously choose their product
locations, then simultaneously set prices in an infinite series of periods. Suppose that firms
collude in prices in the second stage and anticipate they will do so at the product-positioning
stage. In this context, what do you expect the degree of product di↵erentiation to be?20
Answer: Suppose that consumer preferences are uniformly distributed along a interval in
product space (as in the Hotelling model). If firms do not compete on price, then demand
is entirely determined by product position. Given firm j’s product position, firm i’s best
response is to locate next to firm j, to the right of j if j’s position is to the left of the mid
point, to the left of j if j’s position is to the right of the mid point. As a result, the Nash
equilibrium of the product-positioning game has firms locating at the center of the product
space; that is, minimum di↵erentiation takes place in equilibrium.

14.7. Price competition with search costs. Twenty five di↵erent stores sell the same
product in a given area to a population of two thousand consumers. Consumers are equally
likely to first visit any of the twenty five stores. Half of the consumers have no search costs
and purchase at the lowest price so long as it is lower than $45. The other half is willing to
buy one unit of the product up to a maximum of $70 and must incur a cost of $44 in order
to find out about the prices charged by other stores. Each store can sell up to 90 units and
has a unit cost of $25.
(a) Show that, in equilibrium, there exist at most two di↵erent prices.
Answer: Suppose there are three di↵erent equilibrium prices. Half the consumers purchase
at the lowest price, so the the two higher prices are only paid by the high-search-cost
consumers. Since these consumers are uniformly distributed across stores, one of the higher
prices must be a sub-optimal strategy: either buyers turn away from the higher price, in
which case the seller is better o↵ by lowering price; or buyers buy at the lowest price, in
which case the seller is better o↵ by increasing price. See also Salop, Steven, and Joseph
Stiglitz (1976), “Bargains and Ripo↵s,” Review of Economic Studies 44, 493–510; or the
summary discussion in Chapter 8 of Varian, Hal (1978), Microeconomic Analysis, New York:
Norton.
(b) Show that, if there exist two di↵erent equilibrium prices, then the
higher price must be 70.
Answer: If the high price is lower than 70, a firm that deviates by slightly increasing price
does not lose market share since consumers are not willing to pay the search cost. Therefore,
the firm is strictly better o↵. Hence, all firms would want to deviate upwards, so that the
high price must be 70.
(c) Show that the following is an equilibrium: 5 firms set a price of 70
and the remaining 20 firms set a price of 45.
Answer: First notice that, given the search costs for first type of consumers, we can safely
assume that these consumers will not search, rather will compare price to their willingness
to pay (70).
At the proposed prices, profits are as follows: for a firm setting p = 70, demand is given
by 1,000/25=40 and total profit is 40 ⇥ (70 25) = 1, 800. For a firm setting p = 45, total

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demand is 1, 000/25 + 1, 000/20 = 90 and total profit is 90 ⇥ (45 25) = 1, 800.
A p = 45 firm could deviate by setting a lower price. It would get more demand but,
since it is selling at capacity, profit would be lower. It could set a higher price but would
then only keep the high valuation consumers. It could at most make a profit equal to the
profit currently earned by the p = 70 firms, which in turn is equal to its current profit. We
thus conclude that such firm would not want to charge a di↵erent price.
A p = 70 firm could deviate by setting a lower price. Any price below 70 and above 45
leads to the same demand but a lower margin. By setting a price equal or lower than 45,
the firm would get less than what p = 45 firms currently get, which in turn is the same as
a p = 70 firm currently gets.

14.8. Demand for Yoplait yogurt. Statistical analysis suggests that the demand for
Yoplait 150 yogurt is given by a constant term + 1.85 ⇥ Advertising exposure 0.24 ⇥
Advertising exposure ⇥ Number of previous purchases, where “advertising exposure” is the
number of 30-second ads for Yoplait 150 observed by each consumer during the week of the
shopping trip..21 How do these results address the debate over persuasion vs information
e↵ects of advertising?
Answer: The first coefficient, positive, indicates that the more Yoplait spends on advertis-
ing, the greater the probability of a purchase. The second coefficient, negative, indicates
that the more accustomed a consumer becomes to Yoplait, the less advertising expenditures
will influence his of her decision. This result is consistent with the view that advertising
has an informative role (in this case, information about the product’s existence).

Applied exercises

14.9. Advertising campaign. Consider a specific advertising campaign. Based on the

discussion in the present chapter, discuss the nature of advertising expenditures (in other
words, what theory best explains the motivation and e↵ects of advertising expenditures).