Screening, advertising and loss aversion: an essay in behavioural industrial organisation

Nguyen, Kim Tuong-Bao (2012). Screening, advertising and loss aversion: an essay in behavioural industrial organisation Honours Thesis, School of Economics, The University of Queensland.

       
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Author Nguyen, Kim Tuong-Bao
Thesis Title Screening, advertising and loss aversion: an essay in behavioural industrial organisation
School, Centre or Institute School of Economics
Institution The University of Queensland
Publication date 2012-11
Thesis type Honours Thesis
Supervisor Dr Juan Carlos Carbajal
Total pages 76
Language eng
Subjects 14 Economics
Formatted abstract

In this research we extend the framework developed by Koszegi & Rabin (2006), Heidhues & Koszegi (2010), and Carbajal & Ely (2012) to incorporate advertising into a screening model under reference-dependent preferences and loss aversion for product quality. Motivated by the marketing literature, we assume that consumers rely on advertising to form their aspirational quality levels, which are taken as the reference points when comparing between different contracts. As such, our model allows the monopolist to influence directly the reference formation process and internalise advertising into the optimal contract design. First, we fix the reference function and derive the optimal menu of quality price contracts for any given advertising level, following Carbajal & Ely (2012) characterisation of incentive feasible contracts under loss aversion. Second, we let advertising vary and solve for the optimal advertising level using the explicitly derived optimal contracts menu. Our model offers an alternative interpretation for the revenue-generating role of advertising. Using a more simplified setup, we study the relationship between advertising effectiveness and optimal choice of advertising. We show that as long as effective advertising is elastic, the firm should increase advertising as its impact becomes stronger. Lastly, we illustrate our model with an example, the results of which suggest that advertising enables upward distortion of quality from the efficient level. 


 
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