Where Are the Persuaders Hiding?

Will Rinehart has a great essay summarizing the literature on advertising effectiveness. The tl;dr version is that you can can persuade the average consumer to try your product in some contexts, but is it is very very hard. In other words, the idea ad men can easily mesmerize customers into buying their products (as argued in the Hidden Persuaders) is total bunk. 

Why is persuading consumers so hard?

One reason it is hard to persuade consumers is most of them choose not to be persuaded. Many models of advertising treat consumers like passive receptors for ads. You show them words on a screen and somehow it "changes" their minds (kinda like if Coca-Cola created the Snow Crash virus). But that isn't really how consumers make decisions. Instead, consumers actively decide whether to engage with your ad or not. This insight is formally captured in Becker & Murphy's model of advertising. In their 1993 paper, they argue that consumers approach advertisements in much the same way they approach other goods--they consume them up until the marginal benefit equals the marginal cost. If consumers hate watching ads (i.e. the marginal benefit of watching the first ad is negative), then you have to give them something in return for watching your ad. For example, giving consumers free web content like YouTube videos with your ad stuck in the middle is one way to "pay" them to watch your ad. Of course, even if you "pay" consumers to watch your ad with free web content, that is no guarantee they will actually watch it. The costs may still exceed the benefit if the ad itself is not also mildly entertaining. Maybe that's one reason why ad clickthrough rates are so low? 

I don't know about anyone else, but this theory describes how I watch ads. I won't go out of my way to watch your mildly entertaining 30-second commercial. But, if you stick it in the middle of a video on the Philosophy of Mob Psycho 100? Maybe I'll watch....or maybe I won't. Honestly, even when I am getting free content, the benefit from engaging with most ads is too low to bother (I saw this ad 5 times on mute before I realized it was about a car and not a new antidepressant). 

So, if ads are so ineffective, why do companies advertise?

Many econometric analyses look at the consequences of advertising on the average consumer's purchases. However, the actual target of ads is not the "average" consumer. It is the marginal consumer. That person that is just on the fence between buying another unit of your product or not. If you can convince those consumers, you might not only sell more units to them, but the increase in demand might put upward pressure on prices that allows you to sell your goods to other customers at a higher price (this is also discussed more formally in Becker and Murphy). So that is the real question companies have to answer. Does that marginal revenue generated by another dollar of advertising exceeds the marginal cost? Answering that question is very difficult as discussed in Lewis and Rao's paper on the Unfavorable Economics of Measuring Returns to Advertising.  

Coase and the Hog Cycle

[edited on 9/14/2021 for clarity]

If you read this blog, then you're probably familiar with Ronald Coase's work on the importance of transaction costs. But did you know that Coase devoted a substantial portion of his early career to studying the Hog Cycle? He actually wrote 4 separate articles on the subject between 1935 and 1940, but not one makes Dylan Matthew's recent list of Coase's top-five papers. This work is actually really fascinating in the context of economic intellectual history, so here is a quick summary!

The 1932 UK Reorganization Commission for Pigs and Pig Products Report

The Hog Cycle debates all started when the UK Reorganization Commission for Pigs and Pig Products found in 1932 that hog prices followed a 4-year cycle: two years rising and two years falling. The Commission argued that these price fluctuations were due to forecasting errors made by hog farmers and that government intervention could help stabilize hog prices. 

Why would forecasting errors lead to cyclical price fluctuations? Let's walk through a price cycle using an example of the model the Commission used, which is often called the Cobweb model (illustrated below). We begin time at period 1 where hog farmers bring Q1 to the market to sell. Supply is fixed at Q1 this period because farmers can't produce more hogs on the spot, so the price that prevails on the market will be P1. Since this price exceeds the marginal cost of production, the individual producer is earning more revenue on each hog they sell than it cost to produce. 

After selling all their hogs in period 1, the farmers will go back home to produce more for the next sale period. Suppose, as the UK Reorganization Commission did, that the next sale period is in 2 years because it takes that long to produce hogs ready to sell. When deciding how much to produce, the farmer needs to forecast what the price will be in 2 years. Intuitively, you might think the farmers would use the information available on how demand and supply for hogs will shift over 2 years to forecast this price. However, the UK Reorganization Commission instead argued that hog producers just assume the price of hogs in next sale period (period 2) will be the same as they were during the last sale period (period 1).

Because hog producers earned more revenue on each hog than it cost produce in period 1, each producer will individually increase their hog production hoping to earn even more profit in period 2. However, when the producers return to the market in 2 years, they will find that everyone else increased production too and that quantity supplied is now Q2. As a result, the price will plummet to P2 and the producers will actually lose money on each hog they sell (MC < P2). Not learning their lesson, the hog producers again go home decide how much to produce for period 3 based on the assumption that the price next period will be P2. 

Hopefully you see where this is going, even if the hog producers don't. The producers will collectively cut production for to Q3 and prices will go up to P3. Thus, we have a 4-year cycle in hog prices where prices fall for 2 years and rise for 2 years. How long will this cycle continue? That depends on the elasticities of supply and demand. If demand is less elastic than supply, as was believed to be the case in the hog market, then the price swings will continue forever and only get bigger as time goes on. This is why the Commission said government intervention was needed. 

Source: Wikipedia

Coase and Fowler (1935) Take the Cobweb Model to the Data

The Cobweb Model is really clever, but does it actually capture the reality of the hog market? Coase and his co-author Ronald Fowler tried to answer that question by evaluating the model's assumptions. The easiest assumption to test was whether it really took 2 years for hog producers to respond to higher prices. To do this, Coase and Fowler (1935) spend a lot time investigating how hogs are actually produced. They found that the average age of a hog at slaughter is eight months and that the period of gestation is four months. So a producer could respond to unexpectedly higher hog prices in 12 months (possibly even sooner since there were short-run changes producers could also make to increase production). If that is the case, why does it take 24 months for prices to complete their descent? 

Clearly the Cobweb Model is missing something. Maybe the cycle isn't due to forecasting errors at all. However, Coase and Fowler's critics were not convinced. If it wasn't forecasting errors that were driving the Hog Cycle, then what was? "They have, in effect, tried to overthrow the existing explanation without putting anything in its place" wrote Cohen and Barker (1935). Coase and Fowler (1937) attempted to provide an explanation, but this question would continue to be debated for decades.

The Next Chapter

Ultimately, John Muth (1961) proposed a model that assumed producers didn't have systematically biased expectations about future prices (in other words that they had "rational" expectations). Muth argued this model yielded implications that were more consistent with the empirical results found by Coase and others. For example, rational expectations models generated cycles that lasted longer than models that assumed static or adaptive expectations. So a 4-year hog cycle no longer seemed as much of  a mystery. I'm not sure what happened to rational expectations after that. I hear they use it in Macro a bit.  Anyways, if you are interested in a more detailed summary of Coase's work on the Hog Cycle, then check out Evans and Guesnerie (2016). I found this article on Google while I was preparing this post and it looks very good.

References

Evans, George W., and Roger Guesnerie. "Revisiting Coase on anticipations and the cobweb model." The Elgar Companion to Ronald H. Coase (2016): 51.

Coase, Ronald H., and Ronald F. Fowler. "Bacon production and the pig-cycle in Great Britain." Economica 2, no. 6 (1935): 142-167.

Coase, Ronald H., and Ronald F. Fowler. "The pig-cycle in Great Britain: an explanation." Economica 4, no. 13 (1937): 55-82.

Cohen, Ruth, and J. D. Barker. "The pig cycle: a reply." Economica 2, no. 8 (1935): 408-422

Muth, John F. "Rational expectations and the theory of price movements."Econometrica: Journal of the Econometric Society (1961): 315-335.