The Threshold Effect of Advertising on the Intensity of Price Promotions: Using a Rational Expectations Model

Abstract

Due to the downward sloping demand curve, a retailer can use price promotions to induce store traffic. On the other hand, price promotions can bring negative effects that increase consumers' conditional risks over quality, so that the results expected by retailers may not be achieved. This study investigates whether manufacturer advertising can mitigate the negative effects caused by retailer price promotions. A rational expectation model shows that the relation between advertising and price promotions is not unidirectional. A threshold exists that can ensure whether an increase in advertising expenditures reduces negative effects from price promotions. When advertising coverage exceeds this threshold, an increase in advertising expenditures mitigates negative effects and makes price promotions an effective way to build store traffic. Below the threshold, an increase in advertising expenditures might aggravate the negative effects from price promotions and decrease price sensitivity. Accordingly, marketing practitioners can design product pricing decisions depending on whether advertising information crosses this threshold.

Notes

¹Please also see Chen (2010) for the full discussions of the rational expectations model.