Category: Antitrust

Samuel Cook defends advertising on the grounds that it: funds; drives culture; creates competition; and influences, rather than manipulates. I have argued at length against each of these apologies for advertising.

Funding. Yes, advertising does fund newspapers, online search, social media, and many other useful services. But there are better ways to fund services we love, such as charging full price for those services, or voting for government subsidization.

Why are those better funding methods? Because they are less economically wasteful. Funding through advertising involves two kinds of waste.

First, the money that advertisers are willing to pay for advertising represents waste, in the form of profits generated from inducing consumers to pay higher prices for products that those consumers do not actually prefer. In the information age, you don’t advertise to inform, but rather to manipulate (or as Cook would have it, to influence, of which more below), and you should never invest more in manipulation than you can hope to recover from being able to charge higher prices for lower quality products as a result of your promotional efforts. But those higher prices and reduce product quality represent waste — an advertising-induced misallocation of consumer resources. Consumers would be better off paying less for unadvertised products.

The second source of waste from funding through advertising is the expenditure of resources on advertising infrastructure itself. Given that advertising serves only to distort consumer choices, all the money required to actually create advertisements and target them at consumers itself represent a waste — a diversion of productive resources away from more socially valuable uses. Other funding models, such as subscriptions or tax-and-transfer, do not waste resources in these ways.

Suppose, for example, that a newspaper funds itself by selling $1 million worth of advertising. Advertisers would never be willing to spend $1 million on advertising unless they could earn a profit on that investment — through the higher prices for lower quality made possible by the advertising. If the advertisers hope to make a market rate of return on their investment of 8%, then we can infer that consumers lost $1.08 million to advertisers by buying higher-priced, lower-quality advertised products as a result of the advertising sold by the newspaper. To keep things simple, let’s assume that the newspaper offers production as part of its advertising service, so that creation of messages, images, and so on is all included in the $1 million the newspaper charge for advertising. If all these production services cost the newspaper $100,000 to provide, then the newspaper will net $900,000 from its advertising sales that it can spend on news gathering. The net result is that, to fund journalism to the tune of $900,000 using advertising, a total of $1.08 million must be wasted by consumers, and another $100,000 wasted by newspapers, which translates into a total loss to society of $1.18 million.

By contrast, if the newspaper were simply to charge full price to readers, and readers to pay it, then nothing would be wasted in the funding of journalism. Consumers would pay $900,000 for $900,000 worth of newsgathering (or perhaps a little less, to account for the costs of administering a subscription service). Granted, news is a public good for which consumers may not be willing to pay, even if they love it. In that case, the most efficient way to fund newspapers would be through government subsidy. Government would tax those $900,000 from consumers and pay them out to newspapers (less the cost of administering the tax system), again with none of the waste associated with advertising as a funding mechanism.

Would government subsidy be a threat to democracy? Well, it wasn’t for the first hundred years of American democracy, when the federal government heavily subsidized the news by letting newspapers mail paper virtually for free to subscribers through the U.S. Mail, making the American newspaper industry into the envy of the world.

Drives culture. Cook’s argument here is that firms use advertising to convey messages of public importance: “Nike has, for years been on the frontline of effecting social change,” he writes. This is really a variant of the argument that advertising funds socially useful services — here the socially useful service is public messages that promote certain social values. The trouble with this apology for advertising is here again that advertising is a wasteful funding method. Ban commercial advertising, raise taxes by the $3.34 billion that Nike will spent last year on advertising, and then earmark that money for distribution to activist organizations for use in public service advertising campaigns. You would end up with a more powerful public service message, because  Nike’s public service message is weakened by the fact that it’s tied to selling shoes, and consumers would end up better off because many would not be influenced into buying sneakers they don’t need as collateral financial damage associated with Nike’s public service advertising.

Looking beyond this economic argument, it is important to acknowledge here too the many rich critiques of advertising’s influence on culture. Some argue that advertising destroys culture by encouraging people to derive pleasure from consumption. Others argue that it simply crowds out messages that are not tied to commercial ends. Talented young artists simply can’t afford to put up billboards celebrating love, or run Super Bowl commercials celebrating social harmony,  for example, because deep-pocketed advertisers can outbid them for that advertising space every time. Ban commercial advertising, and political advertising — something that I most certainly do not condemn — becomes far less expensive and more common. That’s good for culture and for democracy. The heart of my argument against commercial advertising is not, however, cultural, but economic.

Creates competition. Advertising certainly can create competition, by helping a startup, for example, challenge an entrenched brand. But advertising promotes competition in a way that deprives competition of the virtues we usually ascribe to it. The startup that advertises wins by influencing consumers, not by fielding a better product. When firms advertise to compete, they compete on advertising — which company has the more powerful influence campaign — and not exclusively on the variables that healthy competition is supposed to influence — price and quality.

In a world without advertising, startups have only one way to challenge the incumbent — by offering a better quality product at a lower price. That limitation ensures that competition will tend to minimize price and maximize quality. When firms compete on influence — via advertising — there is no guarantee that the firm that wins will offer the best product at the lowest price; the winner may win instead by advertising best. So while advertising may promote competition, it undermines healthy competition.

True, sometimes a brand is so entrenched that startups cannot enter the market without the aid of advertising, no matter how good their products and how low their prices. But the only solution to this problem that leads to health competition — competition that’s focused on price and quality — is to ban advertising and to use the antitrust laws to break up entrenched brands. Banning advertising itself undermines entrenched brands, because owners of those brands often use advertising to maintain their power. Action under the antitrust laws to compel licensing of iconic trademarks and other intellectual property would undermine brands that are entrenched for reasons other than advertising, such as advantages associated with being first to market. It has been done before.

Influences, not manipulates. Cook takes issue with my characterization of advertising as “manipulative,” arguing that manipulation implies deceit. Good advertising, argues Cook, does not deceive, but rather “shar[es] passion” for a product in a truthful and honest way, “influencing,” rather than manipulating.

Certainly, much advertising influences without deceiving, and any case against advertising must explain what is wrong with such influencing. What is wrong is that truthful, non-misleading advertising can influence consumers into purchasing products that they do not really prefer. Current law regarding advertising, as well as Mr. Cook, assume that the only advertising that can cause consumers to buy products they do not really prefer is deceptive or misleading advertising, which is why the law prohibits misleading or deceptive messaging. But for several decades now, behavioral economists have been quite clear that truthful and non-misleading advertising can also induce consumers to buy products they do not really prefer, by operating on the habit-forming parts of the brain, to the exclusion of the deliberative parts of the brain. Just as countless tourists have died in London by looking — out of habit — in the wrong direction before crossing the street, making an entirely voluntary, though habit-directed, choice to die, even though every last one of them would certainly say that they did not prefer to die, millions of consumers may well voluntarily buy products that they do not really prefer, due to the influence of truthful, non-misleading advertisements that nevertheless appeal to the non-deliberative faculties of the brain.

The trouble with advertising is precisely that advertising influences, in Cook’s sense of the word. My argument is not that influencing itself is wrong. Influence is an essential part of political debate. We want great politicians to move us to be better than we might prefer to be. But commerce is different. The Invisible Hand only works when consumers are in the driver’s seat in markets, imposing their preferences on firms through the choices that they make. Every advertisement that influences a consumer into abandoning those preferences weakens the control of consumers over markets, putting markets into the hands of firms,  and causing markets to serve consumers that much less well.

There is nothing wrong with having a passion for a product and sharing it with other consumers, but when you are paid to do that by a firm, and the firm necessarily uses its funds to give your passion an influence greater than it would ever have were you to express it unaided, as a private citizen, then your passion becomes a method for impoverishing consumers and undermining markets. It becomes a virtuous and well-meaning thing that has been put to wasteful ends.

Cash is just another input. Concentrations of wealth, concentrations of cash, throw firm surpluses to the wealthy. Deconcentrate wealth, deconcentrate cash, and corporate surpluses will fall more evenly across inputs to the firm.

Have you ever paid so much for something that you had to wonder whether it was really worth it? What prices would trigger that feeling for you? $25 for toothpaste? $2,500 for a Broadway ticket? Armies of data analysts are working hard right now to help companies identify and charge those individualized prices to you.

This practice, called “price discrimination” in economics jargon, and “dynamic pricing” by industry, was pioneered in its new data-driven form by the airlines, which explains why you feel uneasy telling the passenger sitting next to you what you paid for your ticket. But serious debate about the merits of the practice has coalesced only in the past year around Broadway ticket prices, as charges for the top shows, such as Hamilton, have spiked into the $800 range.

While consumers rage about the practice, two commentators have leapt to its defense. Harvard economist Greg Mankiw claimed to be “happy about” paying $2,500 for a ticket to Hamilton. James B. Stewart, usually a perceptive critic of business practices, seemed to agree in a recent Times column that complaints reflect “anticapitalist bias.”

Dynamic pricing is neither necessary for capitalism nor consistent with it. But the practice does impoverish consumers, which is why they have good reason to be angry.

Mankiw and Stewart want us to believe that dynamic pricing is necessary for what economists call “rationing:” the problem of deciding which of a group of consumers, all of whom can afford to pay a price sufficient to cover the costs of production, should get access to a product when the supply of that product is limited. There are only 1,319 seats in the Richard Rogers theater in New York, where Hamilton plays, but on any given night many more prospective ticket buyers are willing to pay enough to cover the costs of the production. Rationing determines who gets to attend.

There are many ways to ration. Charging a price equal to cost, and providing access on a first come, first served basis, remains a popular approach. Any restaurant that takes reservations follows this approach, as does Southwest Airlines, which allocates many of the best seats on its flights to those who check in first online.

Another approach, which generates additional profits for businesses, is to grant access only to those who can afford to pay the most. This is what airlines do when they charge a premium for first class seats. Economists once argued that this was the best approach, because alternatives required consumers to waste time standing on lines or getting through to a busy phone number. But online reservations systems, which are virtual queues, have more or less eliminated that problem.

One thing that is not required for effective rationing, however, is dynamic pricing. The distinctive feature of dynamic pricing is the charging of different prices to different groups of consumers. But setting a single fixed price, as Broadway shows did until the early 2000s, does just as good a job. To choose 1,319 Hamilton audience hopefuls, charge the single fixed price that only 1,319 of them are willing to pay.

Mankiw was therefore mistaken when he wrote that only because a scalper could charge him $2,500 was there a ticket waiting for him to buy two weeks before showtime. If the theater, or the scalper, had charged the right fixed price, Mankiw’s ticket would still have been right there waiting for him when he went to buy.

But the ticket would have been a lot cheaper. Dynamic pricing is really about profits. Of the 1,319 Hamilton audience hopefuls who can afford to pay the most, some, like Mankiw, who has reportedly earned more than $42 million in royalties on his popular introductory economics textbook, can afford to pay much more than others. Dynamic pricing allows a ticket seller to segment these hopefuls into groups based on characteristics that suggest how much each is willing to pay, and raise price to those groups that are able to pay more. Broadway’s embrace of dynamic pricing has probably played a role in generating the $1.45 billion profit enjoyed by the industry last year.

But so what if consumers pay higher prices, the fact that they are still willing to buy means that they are still benefiting, right? Wrong. Getting a good deal on a purchase is not just a luxury that the economy can do without. It is the essence of what it means to enjoy a product, whether a theater ticket or a loaf of bread.

When consumers pay prices so high that they wonder whether the deal was worth it, the pleasure they get from the transaction is vanishingly small, because they must give up so much in order to gain access to the product. Because consumers still buy at such prices, the economy continues to grow, and indeed profits soar, but consumers are shut out of the fruits, engaged in joyless consumption, paying a pound of flesh for a pound of meat. By charging prices just low enough that consumers continue to buy, firms help consumers to destroy the lived value of their own wealth, which is why dynamic pricing is the euthanasia of the consumer.

Fortunately, this future has not quite arrived — firms are still learning how to categorize consumers into finer and finer groups – so some of us continue to enjoy good deals. Mankiw certainly got one, declaring that his ticket was “worth every penny.” Clearly, the scalper failed to charge him a price anywhere near the maximum he could afford.

One percenters like Mankiw suffer the least from dynamic pricing because there are so few of them, allowing them to hide among the merely affluent, and enjoy prices targeted at this less fortunate group, at least for now. Mankiw’s ticket was probably priced for lawyers or doctors, not forty-millionaires. The rest of us can try to hide too among the less fortunate, but the deals we get will not be as good, because our incomes do not differ as much from the incomes of other buyers in lower wealth segments.

Stewart observes that dynamic pricing “yields bargains along with premium prices.” But he does not seem to realize that these bargains are not by design. That $39 deal Stewart found for the show Donna Murphy was not meant for him, but for the American of median income – $53,889 — for whom $39 for a show is not something to write home about.

As firms get better at segmenting consumers, they will eventually be able to keep Stewart out of the economy seats, and to class Mankiw with other forty-millionaires, charging him enough ($100,000?) to make him think twice about declaring his good fortune to The New York Times.

Far from being anticapitalist, dynamic pricing eliminates some of the benefits of wealth, because it ensures that the more a consumer can afford, the more the consumer will be asked to pay. The practice takes us a step closer to the world of Marxist fable, in which each takes only according to his need. By contrast, rage at dynamic pricing reflects the rather capitalist desire of consumers to get the most out of their hard-earned cash.

So what should shows do? To their credit, shows have not yet used dynamic pricing to set prices as high as they could, which is why scalpers have made huge profits on resale. Rather than listen to Mankiw and try to capture the scalpers’ profits by raising their own prices, hit shows should fight the scalpers tooth and nail, on behalf of their audiences, perhaps by following the airlines in honoring only tickets presented by named purchasers. And then they should do the decent thing and start to charge prices that cover only their costs, including a reasonable return to investors, but not a penny more.

Stewart worries that without dynamic pricing, shows would be unable to pay their investors. But investors are just another production input, like sets or stagehands, each of which has a finite cost. Dynamic pricing is about what to do with what remains after those costs have been covered.

To be sure, profits from dynamic pricing could stimulate investment in more shows, but the profits also cause consumers paradoxically to derive less pleasure from those shows, as they are forced to give up more and more in order to get access to them.

The question, ultimately, is whether the audience should be made to exist for the show, or the show for the audience. Consumers already understand how that question has been answered by the airlines. As dynamic pricing spreads across the economy, from taxis to rental apartments, we must also soon ask that question of the entire economy. Broadway can take a stand. And consumers can either “get used to it,” as Stewart recommends, or rebel.