Review of Industrial Organization 13: 509522, 1998.

1998 Kluwer Academic Publishers. Printed in the Netherlands.

509

A Dynamic Model of Advertising and Product

Differentiation
CLAUDIO A. G. PIGA?
Department of Economics, University of York, Heslington, York, YO1 5DD, U.K.

Abstract. This paper analyses a differential game of duopolistic rivalry through time where firms can
use advertising and price as competitive tools. Two cases are considered whereby: (1) advertising has
the main effect of increasing market size and firms differ in production efficiency; (2) advertising has
both predatory and cooperative effects in a symmetric market. The former shows that market shares
and advertising shares are positively correlated and that market size increases with the difference
in firms relative efficiency. The latter highlights the differences in the feedback and open-loop
strategies. It is shown that firms advertising are strategic complements and that profits are higher
in the feedback equilibrium because firms advertise more. The applicability of the model in markets
where franchise contracts and dealership agreements operate is also discussed.
Key words: Differential games, advertising, product differentiation, oligopoly.
JEL classification: C72, C73, L13, M37.

I. Introduction
This paper investigates the nature of dynamic advertising and price strategies using
a differential game.1 It develops a model of duopolistic competition with a differentiated product where firms can use multiple competitive tools. The dynamic
nature of the model originates with the assumption that the number of consumers
in the market varies over time as a consequence of the total industry advertising
outlays. We consider two related cases which differ with respect to the way in
which advertising is assumed to influence consumers behaviour.
In the first, advertising is perfectly cooperative (Friedman, 1983a; Martin, 1993).
The investment by one firm determines an increase in the market size which benefits all the firms in the industry in the same way. Thus advertising is a pure
public good and, therefore, under-investment in advertising occurs as a result of
? I am particularly indebted to Gianni De Fraja, Paul Dobson, John Hey, Peter Simmons, Alan
Sutherland, the General Editor of the journal and a referee for the useful comments to a previous
version of the paper. The usual disclaimer applies.
1 See Kamien and Schwartz (1991) and Fudenberg and Tirole (1991) for an extensive treatment of
differential games and related solution concepts. See also Fershtman and Kamien (1987), Driskill and
McCafferty (1989; 1996) and Reynolds (1987) for examples of linear-quadratic games of dynamic
competition. Reinganum (1981) deals with another class of differential games which, like the linearquadratic ones, can be solved analytically.

510

CLAUDIO A. G. PIGA

the model (Fershtman and Nitzan, 1991). Nevertheless, it is shown that this problem is mitigated when firms marginal costs differ: the more efficient firm, which
enjoys a bigger market share, advertises more than its less efficient counterpart.
In this scenario, industry advertising outlays reach a level which is higher than in
the case where firms have identical marginal costs. It follows that the market size
unambiguously grows with the difference in firms relative cost efficiencies.
The theoretical predictions find some evidence in Roberts and Samuelson (1988)
who report some summary measures of output and advertising for the U.S. cigarette
industry. The data for both the high-tar and low-tar markets exhibits the pattern
predicted by the model, i.e. companies with larger market shares also have the
largest advertising shares. Furthermore, Roberts and Samuelson (1988) find that
advertising in the cigarette industry is highly cooperative, although they cannot
reject the hypothesis that it has no effect on the market share.
Our second case departs from the traditional assumption that advertising can
either be cooperative or predatory (Friedman, 1983a; Slade, 1995a) by taking into
account the possibility, as in Roberts and Samuelsons paper, that advertising can
both increase market size and affect market shares. This is achieved by assuming that advertising, besides attracting new consumers on the market, can modify the consumers perception of the product characteristics,2 thus drawing away
customers from the rival firm.
Two important results arise in this second setting. First, in equilibrium, firms
invest more in advertising than in the case where advertising is purely cooperative.
The under-investment effect due to the public-good nature of advertising is offset
by the incentive that firms face in attempting to increase their market shares. In the
model, the extent to which advertising is predatory is measured by a parameter,
. Although predatory advertising creates a prisoners dilemma situation, we show
that steady state profits are increasing in . This is the case when the increase in
advertising expeditures raises the number of consumers in the market.
Second, it is possible to distinguish, as customary in the literature on differential
games, between two alternative equilibrium concepts: open-loop and feedback.3
A striking result of the model is that firms make higher profits when they
play feedback strategies, because they advertise more. Such a conclusion contrasts
sharply with the findings of other papers. Fershtman and Kamien (1987) obtain,
as an outcome of their model of duopolistic competition with sticky price, that
the equilibrium output with feedback strategies is greater than in the open-loop
equilibrium. As a result, open-loop profits are higher than in the feedback equi2 Nelson (1970) distinguishes between search and experience goods. He argues that the attributes

of the former can be ascertained prior to the purchase, while those of the latter are learned only after
purchase and use. Therefore, the first case can be applied to both types of goods, whereas the second
pertains only to experience goods; consumers buying a search good cannot be misled by advertising
because they can always fully evaluate the goods characteristics.
3 Fershtman (1987) derives the conditions under which, as in the first case, open loop and
feedback strategies coincide.

A DYNAMIC MODEL OF ADVERTISING AND PRODUCT DIFFERENTIATION

511

librium. Reynolds (1987) reaches similar conclusions in his analysis of capacity

investments. Perhaps the most notable difference comes from comparison with
Fershtman and Nitzan (1991). They study the voluntary contributions to a public
good and demonstrate that the free-riding problem is aggravated when provisions
are made conditional on the stock of accumulated contributions. More precisely,
they show that lower provisions are made in the feedback equilibrium relative to
the commitment case and, consequently, agents utility is reduced.
Another important result associated with this paper is that it provides the rationale for a puzzling result in Roberts and Samuelson (1988). Their estimates
indicate that firms adopt sophisticated, feedback advertising strategies in a market
where advertising is cooperative. Furthermore, they find that an increase in a firms
advertising in period t will lead to a lower equilibrium level of rival advertising
in period t + 1 or, in other words, that firms have negative dynamic conjectures.
As in Fershtman and Nitzan (1991), firms should then invest less in the provision
of advertising. But Roberts and Samuelsons empirical findings show that firms
choose the joint-profit maximising level for advertising. Such a result is consistent
with the noncooperative equilibrium of the model: profits are higher when firms
recognise the simultaneous effect of advertising on market size and market shares.
The paper also studies the links between multiple competitive tools, namely
price and advertising.4 The asymmetric case shows that a dominant firm charges
a lower price and advertises more, that is, a decrease in one firms marginal cost
is accompanied by a corresponding reduction in price and an increase in the advertising level. Interestingly, equilibrium advertising is unaffected by production
efficiency when firms are identical.
Other papers have studied dynamic advertising within the framework of a differential game. Friedman (1983a) develops a model of oligopolistic competition
assuming that advertising enters into the demand functions of firms. Advertising in
each period increases the stock of firms goodwill in a manner similar to capital.
Since the price that any firm can charge increases with the parameter representing
advertisings degree of cooperativeness, the more cooperative advertising is, the
more each firm advertises in steady state.5 This result is reversed in this paper.
We show that competing firms provide the least possible amount of public good.
Fershtman (1984) sets out a differential game whereby advertising is predatory,
since a firms market share depends on the stock of accumulated goodwill. Equivalent to the present paper, firms that have a lower production cost will have a higher
market share and will advertise more extensively. However, this occurs for different
economic reasons, since the optimal choice for price is not explicitly modelled

4 Slade (1995b) develops an empirical model to explore the linkages through time of firms price
and advertising strategies, finding that: 1) advertising is mildly predatory, although advertising also
causes an expansion in the size of the market; and that 2) price and advertising are, respectively, own
strategic complements and substitutes.
5 The effect on the equilibrium price of an increase in advertising cooperativeness is unclear.

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CLAUDIO A. G. PIGA

there. Furthermore, another difference between the two papers is that the effect of
asymmetry on market size is not considered.
Section II describes the model, while sections III and IV discuss the two cases.
Section V contains concluding comments.
II. The Model
The market is modelled as a straight line with two firms, i and j , located at its end
points (Hotelling, 1929). This corresponds to a situation where each firm supplies
a differentiated product, the characteristics of which depend upon each firms location. Location is assumed to be fixed. Each consumer is identified by the point on
the line which corresponds to her most preferred product specification, consumes
at most one unit of product and attaches a gross value v to a unit of her most
preferred product specification. A product which is at a distance z along a line from
the consumer provides a monetary benefit of v kz, where k refers to the transport
cost (per unit distance). The parameter k measures the sensitivity of consumers to
product specification. The surplus enjoyed by a consumer who purchases a product
a distance z units away at a price per unit p is vkzp. Consumers purchase a unit
of product only if it gives them a positive surplus. There is a marginal consumer,
located at x [0, 1], who is indifferent between buying from either firm 1 or 2. x
satisfies the following identity: v p1 kx = v p2 k(1 x), and is therefore
given by
x=

1 p2 p1
+
,
2
2k

(1)

Consumers to the left of x receive a greater net surplus from firm 1, and therefore purchase from it. Viceversa as for customers to the right of x. Hence, denoting
firm is market share with yi , we have that y1 = x and y2 = (1 x) or, more
succintly,
yi =

1 pj pi
+
, i, j = 1, 2 i 6 = j.
2
2k

(2)

Consumers are assumed to be uniformly distributed along the line with density
N of consumers per unit length. Thus, the demands for output of firms 1 and 2 are
respectively Ny1 and Ny2 .
Firms differ in their constant marginal cost, denoted as ci . If the difference in
marginal costs is great, then the most efficient firm will supply the entire market.
Therefore a condition must be imposed so as to satisfy the constraint 0 < x < 1,
namely | c2 c1 |< 3k. Total output costs are expressed as Ci = Nci yi .
An investment of Ai in advertising determines an overall cost equal to A2i . The
choice of a quadratic advertising cost function for the firms reflects the notion, supported by a considerable body of empirical evidence (Chintagunta and Vilcassim,
1992), that there are diminishing returns to advertising, mainly due to saturation

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A DYNAMIC MODEL OF ADVERTISING AND PRODUCT DIFFERENTIATION

effects in the media which make reaching an additional consumer increasingly

costly.
The dynamic nature of the model originates with the assumption that the variation over time of N depends positively on the sum of both firms advertising
outlays and on an exogenously given parameter, , which reflects the efficiency of
the advertising media. N decays naturally at a rate > 0. Therefore,
dN(t)

= [A1 (t) + A2 (t)] N(t).

N(t)
=
dt

(3)

The advertisings public good nature is shown in (3) by the fact that market
size increases linearly over time with the sum of the two firms advertising outlays.
Under these assumptions, the aim of each firm is to maximise its discounted
flow of profits, given the price and advertising paths of its competitor:
maxAi (t ),pi (t )
s.t. (3),

R
0



et N(t)yi (pi (t) ci ) A2i (t) dt

i = 1, 2

(4)

where is the constant discount rate and the terms in squared brackets represent
instantaneous profit.
Two different equilibrium concepts are considered: open-loop and feedback
(Kamien and Schwartz, 1991). The former assumes that players commit themselves to a strategy which is simultaneously decided at the outset of the game and
cannot be varied at a later stage. The latter takes into account that when the game
has started, players might find it profitable to revise their strategies, if they were
allowed to do so. Feedback strategies, which are conditional on the observation of
the state variable in each period, are therefore subgame-perfect, whereas open-loop
strategies are not.
III. The Asymmetric Case with Perfectly Cooperative Advertising
PROPOSITION 3.1. (a) Equation (4) identifies a game with a unique stationary,
globally asymptotically stable Nash equilibrium, where the firms choices of price
and advertising are given by:
1
2
cj + k + ci
i, j = 1, 2 i 6 = j
3
3



9k 2 + (c1 c2 )2 6k ci cj

Ai =
i, j = 1, 2 i 6 = j.
36k( + )
pi =

(5)
(6)

The number of consumers N at this equilibrium is:

2 9k 2 + (c1 c2 )2
N =
.
18k( + )

(7)

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CLAUDIO A. G. PIGA

(b) The stationary feedback Nash equilibrium coincide with the open loop one.
Proof. The proof of all the propositions are available from the author.
Equation (5) indicates that price increases with transport costs. Higher transport
costs imply that customers are more dependent on their nearest firm, which is thus
able to exert some monopoly power and charge a price higher than that which is
competitive. The effects of changes in the exogenous parameters on the equilibrium market size and advertising levels can be derived from Equations (6) and
(7). Firstly, an increase in k, which reflects increased sensitivity of consumers to
product specification, leads to an increase in Ai , N and, as already discussed, pi .
Thus, when product differentiation is important, so too is advertising. Grossman
and Shapiro6 (1984) derive the same result, although their model differs from the
present in many respects. Firstly, only symmetric equilibria are considered. Secondly, firm is advertising is only predatory, since it can attract those consumers
who would buy a preferred product from firm j , but are not reached by firm j s
advertisements. Lastly, their model overlooks the dynamic effects of advertising.
Transport cost exerts a positive influence on advertising, mainly because of the
monopoly power that it gives to both firms. If k were zero, consumers would be free
to move and buy from the firm which charges the lowest price: a Bertrand equilibrium would occur, with no advertising and demand fixed at the initial starting level.
With positive transport costs, once market shares are determined through price
competition, both firms face a strong incentive to enlarge the number of buyers
whose preferences are nearest to each firms product characteristics: advertising
will then be positive. Therefore, if we interpret the two firms as retailers selling
the product of a common manufacturer, the model provides some insights into the
free-riding problem identified by Telser (1960). He argued that manufacturers will
not in general be able to induce retailers to provide costly pre-sale services even
if those services positively affect final demand.7 Telsers prediction holds here if
we interpret the advertising variable as pre-sale service. Indeed, we find that
service level is equal to zero when the product is perfectly homogeneous (i.e.,
transport cost equal to zero). But positive levels of service are provided when firms
sell a differentiated product, since transport costs grant an exclusive territory to
retailers and therefore protect them from the rivals opportunistic behaviour.
However, the amount of promotional effort depends also, and most notably, on
the firms relative production efficiency. Figure 1 displays the steady state level
6 In their model, advertising conveys information on the product characteristics and thereby helps

consumers to locate their preferred brand. They employ an information technology similar to that in
Butters (1977), whereby advertisements, which quote the price charged by the firm, are used to reach
the consumers randomly.
7 In his model, this is due to the fact that consumption of the services and purchase of the product
are separable: consumers can visit one retailer, take advantage of the pre-sale services and then
purchase the product from another retailer, who does not provide the service, at a lower price.

A DYNAMIC MODEL OF ADVERTISING AND PRODUCT DIFFERENTIATION

A*i

515

ci=10

ci=20

ci=30
ci=40
ci=50
Asi

cj
Figure 1. Steady state advertising of firm i as a function of both firms costs.
k = 20, = 0.1, = 1, = 2, = 0.1

of advertising for firm i as a function of the own and the rival marginal cost.
The straight line represents the advertising, Asi , when firms are symmetric. The
effect of ci and cj on Ai is twofold. Firstly, for given ci , firm i advertising is
an increasing function of cj . As the rivals market share shrinks, the other firm
optimally increases its promotional effort. Quite interestingly, Ai increases with
cj even when ci is still greater than cj . Thus, a general result of the model is that
the dominant firm will exert more promotional effort. Furthermore, each firm will
react to an increase in the rivals price by raising, given (5), its own price and
advertising expenditure. Secondly, the greater each firms own marginal cost, the
smaller advertising outlays are. Therefore, an increase in the production cost will
be followed by a reduction in the firms advertising expenditure.
Figure 2 relates firms marginal costs with the steady state number of consumers
N . The twofold effect previously identified operates in the following manner: if
cj < ci , an increase in cj determines, respectively, an increase and a decrease in
firm is and firm j s advertising expenditures. As the figure shows, the number
of consumers N diminishes as marginal costs tend to the same value. Hence, the
overall effect on the industry advertising is negative. Indeed, when cj = ci , the
number of consumers reaches its lowest possible level, denoted as N s in the figure, as a consequence of the minimal promotional effort exerted from both firms.
When cj > ci , a further increase in cj determines an increase in firm is advertising expenditures that is greater than the decrease in firm j s advertising outlays.

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CLAUDIO A. G. PIGA

N*
ci=10

ci=20

ci=30

ci=40
ci=50
Ns
cj

Figure 2. Number of consumers in steady state, N , as a function of both firms costs.

k = 20, = 0.1, = 1, = 2, = 0.1

Consequently, demand grows. The general conclusion is that advertising strategies

are strongly affected by their nature of public good. When the differences in
marginal costs are not particularly significant, market shares are more or less equal
and firms tend to exert the smallest promotional effort.8 On the other hand, a firm
dominating the market can reap a greater share of the benefits arising from the
investment in advertising. Hence, it will be induced to spend more on advertising.
PROPOSITION 3.2. Steady state profits iss are a decreasing function of a firms
own marginal cost and an increasing function of the rivals marginal cost, i.e.,
iss
<0
ci

and

iss
> 0.
cj

(8)

As far as the strategic use of multiple competitive tools is concerned, Table I summarises the effects of a change in the parameters on the steady state values of the
control variables.
The efficiency of the advertising technology, measured by , exerts a positive
influence on the optimal advertising expenditure. Its effect is partially offset by the
rate of decay . Given (3), we conclude that firms will expend more on advertising
the greater its net cumulative intertemporal effect is.
8 Such a result runs contrary to the usual belief that it is in oligopolies with similar rivals that

advertising tends to be largest.

A DYNAMIC MODEL OF ADVERTISING AND PRODUCT DIFFERENTIATION

517

Table I. Effect of an increase in the parameters on the price and advertising variables equilibrium level

pi
pj
Ai
Aj

ci

cj

+
+

+
+
+

+
+
+
+

x
x
+
+

x
x

x
x

x
x

x indicates no effect.

As may be expected, the coefficient in the advertising cost function negatively

affects the optimal advertising investment. Finally, a higher discount rate implies
smaller advertising expenditures and a smaller number of buyers in the long run.9
Fershtman (1984) reaches similar conclusions both with regards to interest and depreciation rates. The result is not surprising: the more firms discount the future, the
less advertisings long term effects are relevant. Hence, advertising, which exhibits
diminishing return to scale, will tend to be less intense.
IV. The Symmetric Case when Advertising is Both Predatory and
Cooperative
In order to incorporate a predatory effect for advertising into the model, this section assumes that advertising reduces the transport costs by an amount which is
proportional to the firms advertising outlays. This is equivalent to assuming that
advertising modifies firms locations and therefore the consumers perceptions of
the product characteristics. Now, the marginal consumer is indifferent whether to
buy from firm 1 and receive a net surplus v p1 k(x A1 ) or from firm 2 and
enjoy a net surplus v p2 k(1 x A2 ). Its location is now at
x=

1 p2 p1 (A1 A2 )
+
+
.
2
2k
2

(9)

A higher implies a larger predatory effect for advertising. However, to avoid negative transport costs, only values of small enough to ensure that in the symmetric
1
equilibrium Ass
i < 2 , will be considered.
The relationships highlighted in Table I continue to hold in this setting. Thus,
for expositional convenience, all results will be stated imposing = = = 1.
Moreover, given the impossibility of deriving an analytical solution in the feedback
equilibrium when firms marginal costs differ, the analysis will consider only symmetric firms. However, the effect of different production costs on the advertising
9 These results are among the testable hypotheses listed in Feichtinger et al. (1994).

518

CLAUDIO A. G. PIGA

equilibrium, identified in the previous section, continues to hold in the open-loop

equilibrium.10
PROPOSITION 4.1. (a) When > 0, the following strategies constitute a symmetric feedback Nash equilibrium:
A i (N) = N + 3/2

3+ 1

(10)

where
1 = ( k 9)2 + 3 k 2 2 > 0
and

(2 k + 6) 1 + k (24 k 3 k) 54

=

18 3 + 1

(11)

(12)

(b) The resulting stationary equilibrium for the number of consumers, N ss , the
advertising expenditure, A ss
i and price is:
2k



N ss = 27 

1 2 k
3+ 1

(13)

27
k

 

A ss

i =
2 3+ 1
1 2 k

(14)

p = c + k.

(15)

(c) The above equilibrium is globally asymptotically stable. When N(0) 6 =N ss ,

the market size equilibrium time path is N(t) = N ss + (N(0) N ss )e(2 k 1)t

First of all, note from (13) that in order to have N ss > 0, the condition 1 >
2 k, which also ensures global convergence, must hold.
Equation (10) may be interpreted as a dynamic reaction function expressing firm
is advertising as a function of the observed value of the market size. Depending
on whether  > 0 or  < 0, we may say that advertising investments of the
players are, respectively, strategic complements or strategic substitutes (Bulow et
al., 1985). In the following discussion the parameters values are such that  > 0.
Hence, strategic complementarity implies that a higher investment in advertising
at time t will induce the rival to increase investment in advertising at time t + 1.
10 A proof is available on request from the author.

A DYNAMIC MODEL OF ADVERTISING AND PRODUCT DIFFERENTIATION

519

Ass
feedback

A*

open-loop

A ss < 0.5

Figure 3. Feedback and open-loop symmetric advertising in steady state as a function of .

k = 1, = 1, = 1, = 1, = 0.1.

This anticipation therefore helps to offset the free-riding problem observed in the
previous section.
It is noteworthy that Fershtman and Nitzan (1991) obtain a contrasting result
insofar as they find that the severity of the free-riding problem is accentuated when
players follow feedback strategies. This is because, in their model, contributions of
the players are strategic substitutes.
PROPOSITION 4.2 (a) When > 0, the stationary open-loop Nash equilibrium
for the number of consumers, N ss , the advertising expenditure, A ss
i and price is:
N ss = 3/4

2k
3 k

(16)

A ss = 3/8

k
3 k

(17)

p = c + k

(18)

(b) The above equilibrium is globally asymptotically stable.

It is important to note that when = 0, Propositions 4.1 and 4.2 coincide with
Proposition 3.1. However, when > 0, feedback and open-loop equilibria differ.

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CLAUDIO A. G. PIGA
Profit

feedback

open-loop

Figure 4. Steady state profits in the feedback and open-loop symmetric equilibrium as a
function of . k = 1, = 1, = 1, = 1, = 0.1.

The positive quadrant in figure 3 shows the feedback and open-loop equilibrium
advertising expenditures as a function of . The negative quadrant identifies the
values of for which the firm locates away from the centre of the market.
Figure 3 identifies two important patterns. Firstly, when > 0, the promotional
effort is always higher than in the case without predatory effect. In other words,

ss
we have that A ss
i > Ai > Ai . Therefore, the free-riding problem of the previous
section is somehow alleviated, because firms now advertise more in the attempt to
acquire some portion of the rival market. Secondly, firms invest more intensely in
advertising in the feedback equilibrium, as compared to the open-loop one. Given
the positive effect of advertising on market size, steady state profits are higher in
the feedback equilibrium than in the commitment case (Figure 4). Again, this result
contrasts with Fershtman and Nitzans model, whereby the players contribute more
toward a public good in the open-loop equilibrium, which is also characterised by
the highest utility.
A general conclusion is therefore that in markets where advertising has the main
effect of increasing the market size, the joint-profit-maximising level of advertising
can still be attained in a non-cooperative framework if firms perceive that advertising also exerts a positive effect on their market shares. Thus, the model provides
an alternative justification for the results in Roberts and Samuelson (1988). They
show that U.S. cigarette manufacturers choose the joint-profit-maximising level for
advertising despite their finding that advertising is cooperative and firms have negative dynamic conjectures. This is explained mainly by relating the use of feedback

A DYNAMIC MODEL OF ADVERTISING AND PRODUCT DIFFERENTIATION

521

strategies with the avoidance of excessive advertising. In this paper, a higher level
of profits is consistent with the presence of both predatory and market size effects
for advertising.
V. Conclusions
This paper analyses a differential game of duopolistic rivalry through time where
firms can use advertising and price as competitive tools. It assumes a market characterised by perfectly cooperative advertising. We find that the resulting free-riding
problem is less intense when a dominant firm is present in the market. Moreover,
if advertising affects the distribution of market shares, advertising expenditures
grow as the predatory effect of advertising becomes more relevant. Thus, the underinvestment effect due to the public-good nature of advertising is reduced, even if
firms behave non-cooperatively.
The derived results provide useful insights for the analysis of franchise chains,
especially if the definition of advertising is extended to include the improvement in
the service quality or the supply of pre-sale services. It is widely recognised
that franchisees do not appropriate the full benefit that accrues when investing
to improve the service quality or the supply of pre-sale services. On the other
hand, these are both beneficial to the overall reputation of the chain. In order to
prevent horizontal free-riding (Mathewson and Winter, 1985) from occurring, franchisors have to develop an optimal monitoring strategy. Gal-Or (1995) finds that
franchisors have greater incentives to monitor outlets that serve relatively smaller
markets. In our model, firms with smaller market shares exert less promotional
effort and should therefore be more closely monitored.
Unlike Gal-Or (1995), this paper provides clear indications on how the extent
of competition affects the promotional effort. By allowing market shares to depend
on both price and advertising, we find that firms non-cooperatively increase their
promotional investments relative to the case where predatory effect of advertising
is absent. The need for monitoring is thus reduced when the promotional effort by
one franchisee attracts customers who would otherwise patronise another member
of the chain.
Of course, the result is more general and applies to markets where retailers compete by selling products from different manufacturers. Telser (1960) considers the
free-riding problem among retailers and predicts that no pre-sale service would
be offered in equilibrium. Such a prediction does not hold true in this paper, as long
as a certain degree of differentiation characterises the retailers products or, most
importantly, a predatory effect for pre-sale service is taken into account.
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CLAUDIO A. G. PIGA

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