Thursday, 22 September 2016

Consumer choice and the impact of advertising

Depending on who you are reading, one of the assumptions of neoclassical economics is that preferences over their consumption of goods are fixed. I've always thought that assumption was clearly flawed, because in the real world people's preferences clearly change over time. Of course, you make assumptions in order to make models simpler than the real world, but in this case it's an assumption that probably isn't even necessary.

We know that people's preferences change. One obvious example is the case of advertising. If advertising is effective, it should make the advertised good more desirable. That is, it should shift consumers' preferences towards that good. We covered this in my ECON100 class this week, but I thought it would be good to also go through it here.

Consider the consumer choice diagram below. The consumer is initially buying the bundle of goods A, which includes X0 of Good X, and A0 of all other goods (AOG). Point A is on the highest indifference curve the consumer can reach (I0) within their budget constraint (it's their best affordable choice).


Now say there is a successful advertising campaign for Good X. This makes Good X more desirable. In other words, the consumer would now be willing to give up more of all other goods to buy one more unit of Good X. This means that the marginal rate of substitution (the amount of one good the consumer is willing to give up to get one more unit of the other good) has increased. The marginal rate of substitution (MRS) is the slope of the indifference curve. Since the MRS is now larger, the indifference curve becomes steeper at point A (the indifference curve pivots around to the red curve I0').

Now, the bundle of goods A is no longer the consumer's best affordable choice. They can reach a higher indifference curve (I1') by buying the bundle of goods B instead. The bundle of goods B includes more of Good X (X1), and less of all other goods (A1). So, the effective advertising campaign for Good X induces the consumer to buy more of Good X, by changes their preferences (as represented by their indifference curves).

Note that this doesn't mean that all advertising is a good idea though. Even though the consumer is now buying more of Good X (and spending more on Good X, since they are buying less of all other goods), the advertising campaign involves some cost to the firm. To determine whether the advertising campaign was a good idea, the firm would need to compare the additional revenue generated by the campaign, with its cost.

2 comments:

  1. The usual A-level textbook does not cover the effect of advertising on the indifference curve and its MRS. Thanks a lot for this clear explanation, Michael.

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    1. No problem Vincent. One of the standard assumptions of neoclassical economics is that preferences don't change. Which is why a textbook usually wouldn't cover this.

      But clearly the intention with advertising IS to change people's preferences. And we can show it without needing to discard the existing consumer choice model.

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