Another excerpt from my book in progress, Economics in Two Lessons. There’s a partial draft here if you want to read it in context. I could spend a lot more time on the topic of advertising, but much of the ground has been covered in Akerlof & Shiller’s latest Phishing for Phools. As always, both praise and useful criticism are very welcome.

TANSTAAFL and advertising
We saw in earlier that the ‘free lunch’ provided by saloons wasn’t really free in terms of opportunity cost. Rather, consuming the lunch involves forgoing the opportunity of buying cheaper beer at a saloon where lunch is charged for separately

The same point applies to ‘free’ services provided by governments and financed by taxation revenue. The opportunity cost is the private expenditure forgone to pay taxes. This is the point being made by drivers with TANSTAAFL bumper stickers, even if many of them might be unhappy about paying to use ‘free’ public roads.

There are, however, lots of other examples of services provided free of charge by for-profit corporations. These include radio and TV broadcasts, Internet services like Google, Facebook and Twitter and sponsorship for sporting and cultural events.

Obviously, TV and radio stations, like Google and Facebook, are funded mainly by the sale of advertising. Corporate sponsorship is based on the perception that it will create a favourable impression of the company concerned, which is a kind of advertising. How does our analysis apply to advertising?

In thinking about advertising in TV and similar media, we can easily dispense with the claim sometimes put forward by industry advocates, that such advertising provides consumers with useful information. If this were true, firms would not need to pay TV networks or Internet companies to broadcast the ads.

As is shown by the sales of specialist magazines of all kinds, consumers are willing to pay for useful information about consumer products. But no one will willingly consume ordinary ads unless they are packaged with a program they want to watch, or a webpage they want to view.

In fact, the original free lunch provides a much better analogy. Eating a meal or snack, particularly a salty one, increases the desirability of a cold drink, and the bar is there to provide it.

Similarly, advertisements work because watching an ad increases the desirability of buying the associated product. This may be because the ad attaches desirable qualities (such as sophistication or sex appeal) to the product or because it engenders dissatisfaction with the alternatives we are currently consuming.

In terms of opportunity cost, it does not matter whether an ad works positively or negatively. Either way, the opportunity cost of alternative products is increased relative to the value of the product being advertised. In the standard terminology of economics, a successful ad is complementary (in consumption) with the product being advertised.

In terms of our happiness, though, there’s a big difference. The net effect of advertising is almost certainly to reduce our satisfaction with the things we buy, because most of the ads we see are designed to make us switch to something else. And of course, the things that are not advertised, such as quiet leisure time with family and friends, where no goods and services are required and no money is spent, are downgraded even further.

Market prices tell us about the opportunity costs we face, although the cost, like that of the original free lunch, is hidden. We can choose not to watch the ads (and the programs with which they are bundled), and buy the advertised ‘brand name’ products. Alternatively, we can avoid the ads and buy cheaper alternatives, which don’t include the cost of advertising.

The third possibility is that of watching the ads, but buying the cheaper products anyway. If ads work as they are supposed to, this should induce a similar feeling similar to that of eating salty bar snacks but not buying a drink to go with them. That is, we should feel less satisfied with our choice than if we had not viewed the ads for the brand name product, perhaps so much so that we change our minds and buy the advertised product instead.

Many readers will (like the author) probably judge that they are too strong-minded to be swayed by advertising, particularly the uninformative puffery that we get from mass media. But the continued market dominance of advertised name brands suggests that this is an illusion, similar to the one that leads around 80 per cent of us to believe we are better than average drivers.

Opportunity cost is as relevant to advertisers as it is to consumers. In particular, opportunity cost explains why some kinds of goods and services are commonly bundled with advertising, while others are not. The opportunity cost of producing a TV show or an attractive website can be substantial. But once a given program or website has been produced, the opportunity cost of allowing access to it is small (often less than the cost of restricting access).

In these circumstances, bundling the program with advertising may be the only way to cover the fixed costs of production. If so, the availability of the package as a whole makes us better off compared to the alternative, at least on the (strong) assumption that we carefully consider the hidden cost of the ‘free lunch’ we are being offered.

The problem is more complicated when there are alternatives, such as public funding for broadcasting, which might be financed (as it was for a long time in the UK and Australia) by a license fee for television sets. Choice is maximised when both methods of funding are available, but as a matter of political practice, advertising-funded commercial broadcasters will lobby to have publicly funded alternatives shut down or forced to take ads.

The Internet has shown the power, and the limitations, of a third alternative, that of voluntary provision by individuals (as with blogs) or by large co-operative groups (as with Wikipedia). We’ll discuss this more in Lesson 2.

Finally, it’s worth considering the case when we are forced to consume the advertising whether we want to or not, and without receiving any benefit. The most obvious example is that of highway billboard advertising [as distinct from informative signs regarding the services available at a given exit].

The case where the right to put up a billboard is controlled by (for example) a highway authority, and advertisers have to pay is essentially the same as that of ‘free’ TV and radio. Road users pay part of the cost of providing the highway by consuming ads.

By contrast, in the case where neighbouring property owners can display billboards, neither the road users nor the providers get any benefit. In effect, the owner of the billboard is imposing a cost without any intervening market transaction. In the technical jargon of economics, this is a ‘negative externality’ (we’ll look more at this in Section …).