The Advertising Capital Controversy

Abstract

The ongoing debate over the competitive effects of advertising is in large measure a debate over the economic durability of advertising expenditures (see Telser 1968, 1969; Weiss 1969; Bloch 1974, 1980; Comanor and Wilson 1974, 1979, 1980; Ayanian 1975; and Demsetz 1979). Knowledge of this durability is crucial to interpretation of the well-known positive, cross-sectional relation between accounting rates of return and advertising intensity, as measured by advertising to sales ratios. Although other explanations are possible, the main contending hypotheses to explain this relation are barriers to entry and accounting bias. The barriers to entry hypothesis holds that heavy advertising expenditures create entry barriers that make possible persistently above-normal rates of return for firms in industries that advertise heavily. If advertising is a long-lived investment, however, as maintained by the accounting bias hypothesis, the possibility arises that the high accounting rates of return of heavy advertisers, which treat advertising as a current expense, merely reflect a bias arising from the expensing of advertising outlays. Thus, short-lived advertising is conisistent with the barrier to entry hypothesis, while advertising which is a durable investment supports the accounting bias hypothesis. The interpretation of the positive cross-sectional relation between industry accounting rates of return and advertising intensity as evidence that advertising creates entry barriers rests on findings that advertising effects are short-lived. This paper argues that these findings have been biased by observations of marginal rather than average advertising depreciation rates. Then, from studies by Comanor and Wilson and Weiss, new evidence is adduced that advertising is in fact a longlived investment and is unrelated to correctly measured rates of return. The results stand in opposition to the hypothesis of advertisingcreated entry barriers.