Advertising, search costs, and social welfare

Abstract

Analysis of the welfare effect of advertising depends critically upon the effect of advertising on market prices. In many circumstances, advertising that leads to higher (lower) market prices is overproduced (underproduced) from society’s perspective. This paper demonstrates that these predictions may not hold when consumer search costs are important. A model is developed to show how advertising affects equilibrium prices, search costs, and social welfare in monopoly and imperfectly competitive markets. When informative advertising leads to a sufficient reduction in consumer search costs, both consumer and producer welfare may increase even though market prices rise. This conclusion has important implications for policy analysts, because it demonstrates that one cannot test the welfare effect of advertising by determining the impact of advertising on market prices alone. One must investigate the impact of advertising on both market prices and search costs to fully understand the welfare effect of advertising.