A Dynamic Model of Brand Choice When Price and Advertising Signal Product Quality

A Dynamic Model of Brand Choice when Price and Advertising Signal Product Quality Tülin Erdem Haas School of Business University of California, Berkeley E-Mail: [email protected] Michael P. Keane Department of Economics Yale University E-Mail: [email protected] Baohong Sun Carnegie Mellon University, Pittsburgh, PA E-Mail: [email protected] February 2005 (Revised February 2006) Acknowledgements:Thisresearchwassupportedby NSF grantSBR-9812067,“Consumer learningaboutQualityanditsRoleinConsumerChoice.” A Dynamic Model of Brand Choice when Price and Advertising Signal Product Quality Abstract In this paper, we develop a structural model of householdbehavior in an environment where there is uncertainty about brandattributes, andbothprices andadvertising signal brand quality.Four quality signaling mechanisms are at workinthe model: 1) price signals quality,2) advertising frequency signals quality, 3) advertising content provides direct (but noisy) informationabout quality, and4) use experience provides direct (but noisy) informationabout quality. We estimate our proposed model using scanner panel data on ketchup. If price is important as a signal of brandquality,then frequent price promotionmay have the unintended consequence of reducingbrandequity.We use our estimatedmodel tomeasure the importance of such effects.Our results imply that price is animportant quality signaling mechanism, and that frequent price cuts can have significant adverse effects on brand equity. The role of advertising frequency in signaling quality is also significant, but it is less quantitatively importantthanprice. Key words: Consumer Choice under Uncertainty, Bayesian Learning, Signaling, Advertising andPriceasSignalsofQuality,BrandEquity,PricingPolicy,DynamicChoice 1. Introduction Consumer learning about quality of alternative brands of an experience good occurs through several channels. In this paper we estimate a dynamic brand choice model in which consumers learn through four channels: use experience signals, advertising content and advertising intensity signals, 1 andprice signals.The relative importance of these mechanisms has important implications for how consumer demandresponds to changes in price and advertising intensity.Thus,ourworkisofinterestfor bothmarketing andindustrialorganization. 2 Prior workhas modeled a subset of the quality signaling mechanisms that we consider here.For instance,Erdem andKeane (1996) andAnandandShachar (2000) estimatedmodels where advertising content and use experience provide noisy signals about brand attributes. In Ackerberg (2003),advertising intensity anduse experience bothsignal product quality.But,to our knowledge,prior empirical workhas not incorporatedprice as a signal of quality inbrand choice models.Nor has it allowedsimultaneously for the possibilities that advertising may signal qualitythroughbothitscontentanditsquantity. In the theoretical literature, Milgrom and Roberts (1986) developed a model in which price and advertising expenditure signal quality of an experience good. 3 In their model, high quality producers are more likely to enjoy repeat sales.Thus,longrunmarginal revenue from advertising (that generates initial sales) is greater for high quality producers. Kihlstrom and Riordan (1984) developed a model in which advertising expenditure signals quality by conveying informationabout a firm's sunkcosts.Intheir model,highquality raises fixedbut not marginal cost.Thus,by spending onadvertising,a firm signals toconsumers that it thinks it can recover its sunkcosts,since its higher product quality will enable it tocharge a higher price than lowqualityfirms(thathavethesamemarginal productioncost). 4 1 Throughout this paper, we use the terms “advertising intensity,” “advertising quantity,” and “advertising frequency” interchangeably with advertising expenditure. This is legitimate under the assumption that a brand’s expenditure on advertising determines the frequency with which its ads reach consumers. 2 Indeed, the recognition that dynamics in consumer demand can have important implications for market equilibrium has recently led to a burst of interest on the part of industrial organization economists in the estimation of dynamic demand models (see, e.g., Ching (2002), Crawford and Shum (2003), Ackerberg (2003), Hendel and Nevo (2002)). Marketers have been interested in the estimation of dynamic demand models using scanner data for many years. Keane (1997) reviews much of this literature. Some more recent work includes Erdem, Imai and Keane (2003) and Mehta, Rajiv and Srinivasan (2003). 3 Price’s role as a signal of quality has also been discussed by Farell (1980), Gerstner (1985) and Spence (1974). 4 Price and advertising will function as credible signals only if sellers do not find it profitable to "cheat" by conveying false market signals, for example, charging higher prices for lower quality. Two reasons why sellers might refrain from cheating are desire for repeat sales and presence of informed consumers (Tirole 1991). 1 These papers were motivated by Nelson (1970), who suggested that much advertising contains nosolidcontent.He arguedthat firms’ advertising expenditures couldbe rationalizedif the volume or intensity of advertising (rather than its content) served as a quality signal in experience goods markets.This view has beenchallengedby Erdem andKeane (1996), Anand andShachar (2000) andErdem andSun(2002) whoargue advertising does convey information. 5 AndResnickandStern(1977) andAbernethey andFranke (1996),whosystematically analyzed TV ads,concludedthat the large majority docontainsome informationcontent.Thus,it is an empiricalquestionwhetheradvertisingsignalsquality primarilythroughcontentorvolume. Similarly,consumers may alsouse their knowledge of the price-quality relationship that exists ina market toinfer quality from price.Price researchhas shownthat the relationship is category specific.For instance,LichtensteinandBurton(1989) findthat bothobjective quality- price andperceived quality-price relationships are stronger for nondurables.Caves andGreene (1996) foundthat there is a strong positive relationship betweenprice and(objective) quality for frequently purchased product categories that are convenience goods. Rao and Monroe (1989) argue that a strong positive relationship exists for lower priced, frequently purchased product categories,butthatthe relationshipisnotwelldocumentedforother categories. In this paper, we extend the Bayesian learning model of Erdem and Keane (1996) to incorporate bothprice andadvertising frequency as signals of product quality (inadditiontouse experience andadvertising content).Our structural modeling approachwill enable us toevaluate theeffectsofadvertising andprice promotions bothintheshort-runandlong-run. A key issue in marketing is whether frequent price promotions or “deals” could have adverse consequences for brand equity (Aaker 1991), i.e., do frequent promotions reduce the perceived quality of a brand, reducing consumer willingness to pay in the long-run? Using a reduced-form model,Jedidi,Mela and Gupta (1999) concludedthat advertising increases “brand equity” while promotions reduce it.As our model allows consumers touse price and advertising tosignalquality,wewill beabletoinvestigatethesequestionsexplicitly. Of course,price fluctuations due topromotions are a salient feature of most frequently purchased consumer goods markets.Consumers inour model use the history of prices toinfer the meanprice for a brand.It is this meanprice that signals brandquality. Thus,if a brandcuts 5 Anand and Shachar find that increased exposure to ads reduces some consumer’s demand for certain brands. The implication is that consumers learn from the ad content that the brand is not a good match with their tastes. If advertising only signals quality through its quantity, then increased exposure would never reduce demand. 2 its price inweek t,consumers solve a signal extractionproblem todetermine the extent to which this represents a transitory fluctuation around the mean vs. a more permanent decline in the brand’s meanprice. Tothe extent that consumers revise downwardtheir estimate of the brand’s meanprice,theywillalsorevisedownwardtheir estimateofitsquality,reducing brandequity. Recently,Erdem,Imai andKeane (2003) andHendel andNevo(2003) have developed dynamic demandmodels for frequently purchasedstorable consumer goods.In these inventory models,consumers attempt totime purchases tooccur inperiods whenprices are relatively low. Thus,bothinventory andlearning models containa mechanism whereby, if a brandshifts toa strategyofmore frequent“deals,” consumerdemandforthe brandatany givenpricewillfall. Consistent with his prediction, a substantial reduced form literature in marketing, originating with Winer (1986), has shown that the fit of demand models is substantially improvedif they include not just a brand’s current price, but alsosome measure of its “reference price,” typically operationalized as an average of lagged prices. The learning model in which price signals quality,andthe inventory model,provide alternative rationalizations for reference prices. 6 Thus,animportant avenue for future researchis todevelop methods todistinguishthe demandeffects of more frequent promotions operating throughchanges inexpectedfuture prices vs. perceived quality. Given current computational technology, it is not now feasible to incorporate bothconsumerlearning aboutquality andinventory behaviorintoasinglemodel. We estimate our model on scanner data from the ketchup category.

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