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Advertising and the Diffusion of New Products

Author(s): Dan Horsky and Leonard S. Simon


Reviewed work(s):
Source: Marketing Science, Vol. 2, No. 1 (Winter, 1983), pp. 1-17
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ADVERTISING AND THE DIFFUSION OF NEW
PRODUCTS*
DAN
HORSKYt
AND LEONARD S.
SIMONt
This
paper
examines the effects of
advertising
on the sales
growth
of
new,
infre-
quently purchased products.
It is assumed that
producer originated advertising
serves
to inform innovators of the existence and value of the new
product
while word-of-
mouth communication
by previous adopters
affects imitators. Such a diffusion
process
is modeled and tested for the case of
telephonic banking.
It is shown that
advertising
accelerates the diffusion
process
of the new
product.
The
implications
for a firm
introducing
a new
product
and
wishing
to maximize its discounted
profits
over the
product's
life
cycle
are discussed. In
particular,
it is demonstrated that the
optimal
advertising policy
is to advertise
heavily
when the
product
is introduced and to reduce
the level of
advertising
as sales increase and the
product
moves
through
its life
cycle.
Evidence that such a
strategy
is
commonly practiced by
firms is cited.
(Diffusion
of
Innovations;
New
Products; Optimal Advertising)
Introduction
A firm that wishes to introduce a new
product
has to
carefully design
it to
reflect consumers'
preferences
and to
develop
a
well-thought-out marketing
strategy.
One of the more
important marketing
activities to
accompany
the
product's
introduction is
advertising.
In this
paper
we evaluate the
impact
of
the firm's
advertising strategy
on the diffusion
process
of a new
product
and
seek to determine the
optimal advertising policy
the firm
ought
to
pursue.
In
this
analysis
we concentrate on
product
innovations with
long inter-purchase
times
(of
the order of several
years).
*
Received
February
1981. This
paper
has been with the authors for 2 revisions.
tGraduate School of
Management, University
of
Rochester, Rochester,
New York 14627.
tExecutive
Vice-President, Community Savings Bank, Rochester,
New York 14604.
The authors are indebted to Marshall Freimer for his
help
in the
optimization
section of this
paper. They
also thank Subrata Sen for his
helpful
comments. Earlier versions of this more
complete paper
have been
presented
in
meetings starting
with the International
TIMS/ORSA
meeting
in
Athens,
Greece in
1976,
and have been cited in other works
(such
as
by Mahajan
and
Muller
(1979)).
1
MARKETING SCIENCE
Vol. 2, No. 1, Winter 1983
0732-2399/83/0201/0001$01.25
Printed in U.S.A.
Copyright
?
1983, The Institute of
Management
Sciences
DAN HORSKY AND LEONARD S. SIMON
Models
pertaining
to new
product growth
have been
proposed by
Mansfield
(1961),
Bass
(1969)
and others. Some of those models were based on the
premise
that the diffusion
process
is not within the control of the firm and is
mostly generated by
word-of-mouth and social
pressure
to
adopt
the new
product.
The Bass
(1969)
model has been
applied widely
to a whole
range
of
consumer durable
(usually single purchase) products by
Bass and to other
products, including
industrial
ones, by
Nevers
(1972)
and Dodds
(1973).
The
incorporation
of
marketing
activities into the
adoption process
has also been
attempted.
The effects of new
product pricing
have been examined
by
Robinson and Lakhani
(1975),
Bass
(1980)
and Dolan and Jeuland
(1981).
The
possibility
of
incorporating advertising
has been discussed
by Ozga
(1960), Stigler (1961),
Gould
(1970),
and Dodson and Muller
(1978).
The
following
section
presents
a diffusion model
explicitly incorporating
the
effects of
advertising. Next,
a case
study
for a new
product
is examined to
provide
an
empirical
test of the model.
Finally,
the
optimal advertising policy
for a firm that wishes to maximize its
profits
over the
product
life
cycle
is
derived.
The Diffusion Model
Researchers of the innovation
process
such as
Rogers (1962)
have demon-
strated that most new
ideas, including products
and services
produced by
business
enterprises,
follow a well-defined
pattern
in
diffusing through society.
In the new
product context,
this research
implies
the existence of two
groups
of new
product buyers:
those who
adopt
the
product independently
of others
-the innovators-and those who are influenced
by
others-the imitators.
These
premises
will also serve as the basis for our model.
The likelihood that an individual who has not
purchased
a new
product up
to a
specific
time will do so at that time is
hypothesized
here to be related to
the amount and form of information available to him about the
existence,
quality
and value of the new
product. Specifically,
it will be assumed that
there are two main
types
of sources which
convey
information to
potential
consumers:
(1) producer originated advertising
and other
press reports
which
inform the
innovators,
and
(2)
individuals who have
already adopted
who
inform the imitators
through
word-of-mouth communications and other
means.
Through advertising,
the
producer
informs the innovators that the
product
exists and makes claims about its
quality.
The
utility
which these
type
of consumers
expect
from the new
product
is
large enough
to
persuade
them
not to
forego
the
opportunity
of
using
the
product
in favor of a
delay
to find
out more
experience-based
information
(from
friends and
others)
about its
quality.
In
fact,
since the consumer cannot
sample
the
product by himself,
as
he would have done with a
frequently purchased relatively inexpensive pro-
duct,
the imitator will await the
experience
of others while the innovator will
accept
the
producer originated
information such as
advertising
and in-store
product displays.
Other
positive
information about the
producer
will enhance
the effectiveness of his
advertising
to innovators. This is
probably
one of the
reasons
why "family" (parent company)
names are used more often for
brands of durable
goods
as
opposed
to nondurable ones. In nondurable
2
ADVERTISING AND THE DIFFUSION OF NEW PRODUCTS
frequently purchased goods
the
producer
has little incentive to
provide
mis-
leading
information about his
product
as his
long-run
sales are
largely
determined
by repeat purchases.
In
durables,
the consumer realizes that
by
using
a
"family"
name a
producer
has reduced his incentives to
provide
misleading
information because its
consequences
will also be borne out
by
his
other
product
lines.' In addition to
producer originated
information the
innovator will follow free
publicity
in the form of
press reports
which are
likely
to be
generated
about an innovation and will seek information from
other
objective
sources such as Consumer
Reports.
As to the
imitators,
their
likelihood to
adopt
the new
product
increases with an increase in the number
of
previous adopters.
There are several reasons for this
relationship.
Earlier
researchers cited the fact that
adopters actively pass
on information about a
new
product by
means of word-of-mouth communications and a
larger
number of them will enhance this
activity. Further, they argued
that the
growing
number of
adopters
also
provides
information to
nonadopters
about
their
being increasingly
in a
minority position,
thus
creating
social
pressure
to
adopt.
In
addition,
we
conjecture
that the
availability
of more
previous
adopters
reduces the costs of
finding
information for the
nonadopters;
and
that the fact that
many
have
bought
the
product provides by
itself
positive
information about the
quality
of the
product,
thus
reducing
the risk involved
in its
purchase.
Specifically,
we will assume that the conditional
probability, P(T),
that a
purchase
will be made at time T
by
an individual who has not
purchased up
to that
time, equals:
P(T)=
a +
plnA(T)+ yQ(T) (1)
where
A(T)
is the level of
producer's advertising expenditure
at time T and
Q(T)
is the number of
people
who have
already adopted by
that
time; f/
and
y represent
the effectiveness of these
respective
information sources and a
represents
the information
conveyed
to the innovators
through
alternative
means such as
press reports. Equation (1) represents
the
average probability
of
purchase
across the
population
of
nonadopters,
which is
composed
at
any
point
in time of both innovators and imitators. The
specification
of the
average probability
does not
preclude
the
possibility
that if no such
totally
distinct
segments exist,
each individual is a mixture of an innovator and an
imitator and
accepts
information from all sources.2
Assuming
that the number
of eventual initial
purchases
will be
N,
the number of individuals who will not
have
adopted
the
product by
time T is
[N
-
Q(T)].
The
expected
rate of
product
sales at time T is therefore:
S(T)= Q(T)=
P(T)[N-Q(T)], (Q(T)=
dQ(T)/dT).
(2)
'These issues of
misleading advertising
are more
broadly
discussed
by
Nelson
(1974),
Rosen
(1978),
and Verma
(1980).
2For a discussion of the
adequacy
of
aggregate
models in
describing
a
heterogeneous popula-
tion,
see Givon and
Horsky (1978).
3
DAN HORSKY AND LEONARD S. SIMON
Combining (1)
and
(2)
leads to our model of new
product
sales:
S(T)
=
[a+
+
PlnA(T)
+
yQ(T)][N- Q(T)]. (3)
This model
incorporates
two
commonly accepted properties
of
advertising:
lagged
effects and
diminishing
returns. The inclusion of the first is evident
by
the fact that an increase in
advertising
in a certain
period
will not
only
influence innovators to
buy
in that
period,
but these innovators in the
following periods
become
part
of the stock of information
conveyors,
Q(T),
thus
increasing
the
probability
of further
purchases.
The
diminishing
returns
property
is
incorporated
in two
ways. First,
over time the number of remain-
ing nonadopters decreases, making
additional
advertising applicable
to fewer
people and, second,
on an instantaneous basis the natural
log
transformation
reduces the effectiveness of
higher spendings.
It is
possible
that there are also
instantaneous
diminishing
returns to the
impact
of
previous adopters, Q(T).
However, given
the
ample
statistical evidence in
previous
studies on the
impact
of
Q(T),
no transformation of this kind was
attempted.
Diffusion models discussed in the
past
are either
special
cases of model
(3)
proposed
here or
closely
related to it. Let us assume that the rate of advertis-
ing
is
kept
at a constant
level,
which
implies
that a +
f lnA(t)
= ).
Equation
(3)
then reduces to
ST) =[ Q(T)=[][N-
Q(T
)]
=
fN
+
(yN
-
) Q(T)
-
y[ Q(T)]2. (4)
The new
product growth
model of Bass
(1969)
is identical to model
(4).
Bass
does not relate
f
to
advertising
but rather to innovativeness. Dodson and
Muller
(1978) hypothesize
that
(
is a result of
advertising
and other
marketing
activities but treat it as a constant.3 Models of information
diffusion,
which
determine the number of individuals that are aware of a new
piece
of
information, explicitly
introduce the effects of
advertising. Stigler (1961)
assumes that individuals are informed
through advertising )(T)
=
/3A
(T),
but
does not consider word-of-mouth effects
(i.e.,
he assumes that
y
=
0). Ozga
(1960),
on the other
hand,
assumes that information is
spread by
word-of-
mouth but that the likelihood that a
knowledgeable
individual will transmit
this information can be increased if he is reminded
by advertising. Ozga's
assumption
that
y
is a function of
advertising
while 4 = 0 is not
adopted
here
3The Dodson and Muller model is more
general
than the model
presented
here on different
grounds.
It breaks the
nonadopting population
into a nonaware
subgroup
and a
subgroup
that
knows about the
product
but has not
yet bought
it. While such
segmentation
seems
reasonable,
implementation
of the model would
require
data on the sizes of these
subgroups.
Such data are
usually
not available.
4
ADVERTISING AND THE DIFFUSION OF NEW PRODUCTS
since it is
likely
that in the context of new
products,
the
primary
effect of
advertising
is to be a direct tool for
disseminating
information about the
existence of the new
product.
The effect modeled
by Ozga appears
to be of a
second order nature.
In this context of
infrequently purchased products
we shall not deal
empirically
with
marketing
activities other than
advertising. Nevertheless,
it is
worth
noting
that activities such as sales force
efforts, price changes
and
product
modifications are not
likely
to
change
the basic structure of model
(3).
For
example,
sales force efforts when used
by
the firm can be added
directly
into model
(3)
in a similar functional form to that of
advertising.
In
fact,
in
capital goods industries,
the sales force would
probably
be used in
place
of
advertising
as a more efficient
conveyor
of information. As to
prices,
due to
reductions in
production
costs as a result of
learning,
and due to
potential
or
real
competitive pressure,
substantial
price
reductions can be
expected during
the
product's
life
cycle.
These reductions will
place
the
product
within the
budgetary
limitations of a
greater
number of
potential buyers,
thus
expanding
the eventual number of
adopters,
N. This view of ours on the
impact
of
price
changes
is different from that of other
researchers,
such as Robinson and
Lakhani
(1975),
Bass
(1980)
and Dolan and Jeuland
(1981),
who
essentially
assumed that
price changes
will
change
the
purchase probability
and not the
potential,
N. With
respect
to
changes
in the nature of the
product,
it should be
expected
that firms will tailor their
products
to different
segments
as the
interests of those
segments
become
apparent and,
in
addition,
when
technolog-
ical advances are made. The effect of this
activity
is also
likely
to manifest
itself in an
expansion
of the eventual number of
adopters,
N. The
incorpora-
tion in model
(3)
of those two latter activities of
price
and
product changes
will
not, however,
be
trivial;
it will
require specific modeling
of the time
behavior of the
potential,
N.
The
pattern
of a new
product
sales over time
depends,
based on model
(3),
on two
components:
a
probability
to
adopt
which will
typically
increase over
time and the number of
remaining potential buyers
which will decrease. The
actual
pattern
to be observed for
any given
innovation will
depend
on its
intrinsic
value,
which will determine
N,
and on the effectiveness of the various
sources which
convey
information about it. These are
represented by
the
parameters
of
equation (1).
Let us
assume,
for the sake of
illustration,
that the
rate of
advertising
is
kept
at a constant
level,
and examine then first the time
behavior of model
(4).
The first derivative of that model is:
S
=
Q[
Ny
-
-
2yQ(T)]. (5)
For
products
with the same eventual market
size, N,
three distinct sales
patterns
are
possible
for
(4),
and
they
are
depicted
in
Figure
1. If the
product
is a
promising
innovation for which the
experiences
of innovators are not
good
enough
to
generate
effective word-of-mouth
communications,
then most of the
product's buyers
will remain innovators. The
promotional
activities will in this
5
DAN HORSKY AND LEONARD S. SIMON
Ny>
4 +
/2yoN
Ny>
,
Ny<
TIME
FIGURE 1. Sales Patterns of New Products.
case be more effective than word-of-mouth
communications,
4 >
yN.
That
is,
S of
(5)
will
always
be
negative
and the sales curve will start at a
high
level
and then decline. It should be noted that
adopters'
bad
experience
with a
product can,
in terms of
(4),
at most result in
y
=
0,
but not lower
(negative).
The reason for this is that while
"negative"
word-of-mouth will be
generated
and no imitators will
adopt,
the
purchases
of innovators will not be affected.
Those, by definition,
do not
pay
attention to word-of-mouth information-
positive
or
negative. If, however,
the new
product
fulfills the
expectations
of
innovators,
then word-of-mouth communications will be
generated
and the
adoption process
will be
mainly dependent
on imitation. Word-of-mouth
communications will
be,
in this
case,
more effective than the
promotional
activities, yN
>
,.
Based on
(5),
S will first be
positive,
then
zero,
and
finally
negative.
The sales curve
correspondingly
will
rise, peak
at
Q(T)
=
(N
-
/y)/2,
and then decline. If word-of-mouth communications are even more effec-
tive,
such that
Ny
> + +
2yf)N, then,
based on an examination of
S,
there
will be an inflection
point prior
to the
peak
in addition to an inflection
point
after the
peak (see Figure 1).
That
is,
not
only
will sales rise in the initial
periods,
but
they
will do so at an
increasing
rate. If
advertising
is not
kept
at a
constant,
which is the case in most real world
problems,
then its
magnitude
will
impact O
and cause a shift in the time distribution of sales. The
possible
use
by
the firm of its
ability
to shift the sales curve
through advertising
is an
issue which will be addressed later.
Empirical
evidence that in fact the sales curve of
infrequently purchased
products
follows the
pattern
described in
Figure
1 is
provided
in
many studies,
including
the ones cited earlier.
Contrary
evidence that the
product
life
cycle
sometimes does not follow such a
pattern
is
provided
in Buzzel
(1966),
Cox
(1967),
and Dhalla and
Yuspeh (1976). However,
it should be noted that the
latter evidence
mostly
referred to
frequently purchased products.
In those
there is no reason for the
previous patterns
to hold because the
assumption
of
6
ADVERTISING AND THE DIFFUSION OF NEW PRODUCTS
a
single purchase
(and
as a result of a
decreasing remaining potential) does
not hold. Different models which account for
repeat purchases
such as
by
Parfitt and Collins
(1968)
and
Blattberg
and
Golanty (1978)
have to be
used
for such
products
and are in
agreement
with such data.
Empirical Investigation
The diffusion model
developed
in the
previous
section is based on the
assumption
that
advertising,
in addition to
word-of-mouth,
impacts
the inno-
vation
process.
This
hypothesis
will be tested now
using
data on a
banking
innovation. This section describes the
innovation,
devises methods to test
model
(3),
and
presents
the results of a formal
empirical
test. Then other
empirical support
for our
findings
is cited.
Telephonic Banking
Banks have
long attempted
to make themselves more and more convenient
to consumers. This has been done
through expansion
of branch
networks,
establishment of
bank-by-mail,
and other
systems
for
delivering
services.
Attempts
to increase consumers' convenience have involved new
product
introductions based on electronic transfer of funds instead of
paper-oriented
systems. Among
these are
point-of-sale
terminals in
supermarkets,
automated
teller machines which consumers can
operate themselves,
direct
deposit
of
paychecks,
and
telephone augmented
switches from one account to another.
The
product
we shall examine in this
study
is a
telephonic banking system.
It works in the
following
manner: a consumer
opens
a
savings
or a
checking
account at a financial institution and
provides
the institution with the names
and
personal
account numbers of all the merchants whom the consumer
wishes to
pay through
the
system.
These merchant names and account
numbers are cross referenced
against
the consumer's account number in the
bank,
and the consumer is
given
a confidential
personal
identification num-
ber. When the consumer wishes to
pay
a
bill,
he/she
calls the bank and
provides identifying
information such as
name,
secret code number and
account number at the bank and the merchants and amounts to be
paid.
This
can be done from either a TOUCH-TONE
telephone
or a
rotary
dial tele-
phone, and,
correspondingly,
either the
computer
or a live
operator repeats
back to the consumer
exactly
the information
supplied
and the net balance
remaining
in the account after these
payments.
Telephonic banking systems
of the
type
described above were first intro-
duced
by
three banks in
October,
1974. One of these banks had difficulties
with state
banking
authorities
regarding
the
legality
of the service and sus-
pended
the service for six months until
April,
1975 when these
problems
were
resolved. Three other banks introduced the service
by
the middle of 1975. All
these institutions were mutual
savings
banks which felt that the
product may
serve as a substitute for
checking
services which
they
were
legally prevented
from
offering
at the time.
Currently
the
product
is
being
offered
by
hundreds
of financial institutions of various
types.
7
DAN HORSKY AND LEONARD S. SIMON
The data used in this
study
to test the model consists of five out of the first
six banks that introduced the service
(the
sixth bank did not
provide
us its
data).
The five institutions are located in five different Standard
Metropoli-
tan Statistical Areas
(SMSA) ranging
from the East Coast to the Midwest.
The
population
of the SMSAs varies between
390,000
and
4,820,000 (U.S.
Census
of Population,
1970).
As of June
30, 1976,
the
largest
institution had
$1,845,000,000
in assets and the smallest
$643,000,000.
In three of the five
cases,
the banks studied were the
largest
thrift institutions in their SMSAs.
The introduction of the new
product
was
accompanied by
both
advertising
and free
publicity
in the
press
and electronic media. Each of the banks studied
reported
to us its
monthly
sales and
advertising
data. The sales
figures
were in
number of
newly opened
accounts and the
advertising outlays represented
the
total
expenditure
on
advertising
in
media,
direct mail and
point-of-sale
mate-
rial. None of the banks
changed
their
pricing policies during
the
period
analyzed (October
1974-December
1976).
In terms of
product modifications,
some of the
savings
institutions introduced
checking
services for the first time
during
this
period. Moreover,
some banks
began marketing
the bill
paying
service
together
with their statement
(as
opposed
to
passbook)
accounts. The
periods following
the introduction of the modified
products
were not included
in the data as the
potential
was
likely
to have
changed
and our
objective
is to
test the
impact
of the informational sources.
Only
one of the banks
analyzed
here faced
any competition by
a rival new
product designed
for the same
purpose during
some of the
period
under
study.
That
period
was also ex-
cluded.
Estimation and
Empirical Findings
The discrete
analog
of model
(3)
is needed if discrete time series data is
going
to be used to estimate its
parameters.
This discrete
analog
is:
ST
=
(a
+
/lnAT
+
YQTe-)(N
Q-
T-). (6)
As can be
observed, (6)
is nonlinear in its
parameters a, ,/, y
and N.
Nevertheless,
their estimation can be
performed through
linear
regression
of:
ST=
a[(N- QT-1)]
+
i[lnAT(N
-
QT,)]
+
Y[
QT-(N
-
QT-1)], (7)
when a search is made over different values of N for that value which
minimizes the disturbance sum of
squares.
This
procedure
will
yield
estimates
identical to those which would have been obtained from nonlinear estimation
of
(6).
Cross-sectional
aggregation
of the time series data
pertaining
to the five
locales was not
attempted
as the
magnitudes
of the
parameters,
such as the
potential N,
were
expected
to
vary
across locales due to cross-sectional
(city)
8
ADVERTISING AND THE DIFFUSION OF NEW PRODUCTS
TABLE 1
Estimates
of
the
Diffusion
Model Parameters
Promotional Effects Word of Goodness
Potential
Publicity Advertising
Mouth of Fit Number of
Monthly
City
N
al 10+3 . l
10+3 y 10+5
R2
Observationsa
A
1,700
1.52 2.99 3.64 0.66 14
(4.1)b (1.77) (1.29)
B
3,600
0.64 1.32 2.08 0.91 16
(0.17) (0.35) (0.32)
C
6,200
0.57 0.89 1.28 0.82 20
(0.19) (0.21) (0.61)
D
21,500
1.53 0.23 0.40 0.74 21
(0.70) (0.10) (0.11)
E
22,800
1.17 0.15 0.29 0.82 13
(0.43) (0.04) (0.07)
aThis is
frequently
less than the
period
for which the bank has been
offering
the
service due to elimination of observations in which
expanded
services
(modified prod-
ucts)
were offered.
bValues in
parentheses
are standard errors.
differences and differences in the
products
themselves. The
parameters
of
(7)
were therefore estimated for each locale
separately. Examining
the R2 values
obtained for each bank
separately
while
searching
over different values of N
revealed that the R2 values define a unimodal function with a
unique
solution.
Further the R2 function was sensitive to
changes
in the value of N
(not
a
relatively
flat
peaked function).
The estimates for the
parameters
of model
(7)
and the
corresponding
R2 found for each of the banks are
reported
in Table 1.
The estimates and their standard errors demonstrate that the effects of
advertising
and word-of-mouth are
statistically significant
in all locales. Given
the fact that
(7)
is
nonlinear,
the standard errors of the
parameters a, fl,
and
y
are
likely
to be contaminated
(probably increased) by
the standard error of N.
As a
result,
another accurate
way
to examine the
significance
of /8 and
y is
through
likelihood ratio tests described in
Horsky (1977a);
these were
per-
formed and these coefficients were all
significant
at the 0.05 level.
Further,
given
the over identification of
(6),
a
predictive
test
(as discussed
by Horsky
(1977a))
to
attempt
to
reject
the model is
possible.
This was also carried
out,
and it failed to
reject
the model.
The
magnitudes
found for the
potential
N are of interest. In the
period
analyzed
for banks A and
B,
these banks marketed a
product
which does not
include all the features
provided by
the other banks. It is thus reasonable that
the
potential
for that
product
is more
limited,
resulting
in a
comparatively
smaller N in those
locales,
even when
accounting
for
population
sizes. Had a
much
larger
set of banks
provided
us with their
data,
a cross-sectional
analysis
9
DAN HORSKY AND LEONARD S. SIMON
of N as a function of the nature of the
product
and local
demographics (such
as
population size, average disposable
income, average age, etc.)
could have
been conducted.
Clearly
one would
expect
the value of this
particular
innova-
tion to be
especially high
for individuals with a
higher
value for their time.
The value of the different information carriers in terms of their effect on the
number of
adopters
in a month can be calculated
by multiplying
the coeffi-
cients of
AT
and
QT-
I,
and
Y
respectively, by
N-
QTr-.
These values will
be
larger
in the initial
period
as no one has
adopted
the
product yet (i.e.,
Qo
=
0,
and the number who
may adopt
the
product, N,
is
largest).
In the
initial
month,
the value of the first $1000
of
advertising, Nfl
n 1000
ranges
from 24 to 39
adopters, depending
on the locale. At that
time,
the
potential
value of a
single previous adopter
as a word-of-mouth carrier and
generator
of
new
sales, yN, ranges
from 0.062 to
0.086,
in terms of new
adopters.
The
monetary
returns from these new
adopters
could also be calculated if the
profitability
from an additional
telephonic banking
account was known. It
should be noted that when
taking
into account the
lagged
effects of advertis-
ing (which operate
as described earlier
through
a
goodwill
in the form of
previous adopters)
the
long-run
effects of those $1000 of
advertising
are
considerably larger
than the one calculated above.
Our
empirical findings
on the
impact
of word-of-mouth are both in
princi-
ple
and in
magnitude
in
agreement
with
previous
works. Bass
(1969)
and
Lawton and Lawton
(1979),
who studied a
long
list of consumer
durables,
report
the
yearly
values of
yN
to be in the
range
of 0.17-0.66 and
0.33-0.57,
respectively.4
Cable
television,
a consumer
service,
was examined
by
Dodds
(1973)
and Lawton and Lawton
(1979); they report
the value of
yN
to be 0.44
and
0.54, respectively.
The
monthly
values we found for
yN
were 0.062 to
0.086. On a
yearly
basis our values are
slightly higher,
a
finding
which can be
explained by
the fact that the
banking
innovation did
progress
faster than the
above durables
along
its life
cycle.
In terms of
advertising,
since no
previous study attempted
to measure the
impact
of
advertising
on the diffusion
process,
no direct cross-validation of
this result is
possible.
However,
Peles
(1971)
used linear models and
reported
that total
advertising outlays by
all car manufacturers had a
positive impact
on the car
industry
sales.
Further,
he found
by examining
the stock of cars in
operation
that
advertising
shifted the demand for cars in such a
way
that it
occurred earlier on account of future sales. Benham
(1972) reports,
based on a
cross-sectional
analysis,
that in states where
optometrists
are
prohibited
from
advertising
their
services,
it is much more difficult for new
optometrists
to
establish themselves. Another source of indirect
support
are studies
examining
the effects of
advertising
on the first
(trial) purchase
of nondurable
goods.
Both Nakanishi
(1973)
and
Blattberg
and
Golanty (1978) report
that advertis-
ing
is effective at that
stage. Finally,
based on Nelson
(1974),
the
average
advertising expenditure
as
percent
of sales was for
"experience
durables" such
4Bass
(1969)
defines the coefficient
preceding Q(T)
in
(4)
as
y/N.
As a
result,
the values we are
reporting
here for Bass and others are in their notation the values of
y.
10
ADVERTISING AND THE DIFFUSION OF NEW PRODUCTS
as
appliances
3.3%,
while for
"experience
nondurables" such as cereal it was
4.8% and for beer 6.8%.
Clearly,
some if not most of this
appliance advertising
is
competitive
as
opposed
to informative.
Nevertheless,
these
percentages
imply
that based on the
experience
of
producers, advertising
of
durables,
while
not as effective as that of
nondurables,
is still an effective communicative
device.
Optimal Advertising Policy
The above
empirical study
indicates that a diffusion model should include
advertising
as a source of information to innovators. Based on this
result,
it is
evident that a firm
could, apart
from
just forecasting
the eventual number of
adopters
and the
timing
of the
peak
in
sales,
also
partially control, through
the
level of
advertising,
the
shape
of the sales function. For
example, returning
to
Figure 1,
a firm
could, by increasing
its
advertising outlay,
increase
o (which
is
advertising dependent
in the
general model, f(t)
= a +
plnA(t))
in such a
way
that the time distribution of sales will be shifted. Given this
ability,
the
firm will seek to
implement
the
advertising policy
which will lead to maximiza-
tion of discounted
profits
over the
product
life
cycle.
Thus,
the
optimization problem
is to
identify
the
advertising policy A(t),
which will maximize:
7
=
f[ gS(t)-A
(t)]e-tdt
=f0?
g[N - Q(t)][a
+
lnA(t)+y yQ(t)]-
A(t)}e-'tdt
(8)
where
g
=
gross margin
exclusive of
advertising,
and 0
=
cost of
capital.
It will
be assumed
initially
that the
gross margin,
g,
is a constant which does not
vary
in time. We relax this
assumption
later in this section. The rate of sales is
represented
at
any
time
by
Q=[N-
Q(t)][a
+
/lnA(t)
+
yQ()];
Q(t
=
O)=
O, Q(t
=
oo)
=
N.
(9)
Equations (8)
and
(9) represent
a
dynamic system
with one state
variable,
Q(t),
and one control
variable,
A
(t).
To determine the
optimal
control for the
above
system,
we shall use
Pontryagin's (1962)
maximum
principle
as an
optimization technique.
In that
technique
the above
problem
is
equivalent
to
maximizing
the
Hamiltonian,
which is defined as
H(t)
=
iT +
(t)Q(t),
where
4(t)
is an
adjoint
variable defined
by
,
=
-aH/aQ.
Thus,
for the
problem
at
11
DAN HORSKY AND LEONARD S. SIMON
hand:
H(t)
=
g[N- Q(t)][a
+
8lnA(t)+ yQ(t)]
-A
(t))e-t
+4
[N-
Q(t)][a
+
/8lnA(t)
+
yQ(t)]
=
lnA
(t){ f[N
-
Q(t)][ ge-'
+
]}
-
A
(t)e-0'
+[a
+
Q(t)]{[N- Q(t)][
ge-t
+
4]}, (10)
4 =
[ge-0
+
] [a
-
yN +
/3lnA(t)
+
2yQ(t)].
(11)
Boundary
conditions for the
adjoint
variable
iA,
defined
by (11),
can be
determined since at some
large t,t,
when
Q(t) N,
there are no costs or
revenues associated with
being
at a
specific
value of
Q,
and thus
A4(t)=
0.
To determine the
properties
of the
Hamiltonian,
the time behavior of 4
needs to be examined. Given the above
boundary
condition on
4/,
careful
examination of
(11) up
to time t reveals that from the time that
Q(t)= N/2,
4,
has to
approach
zero from below with
positive ge-t
+ 4- and 4,. Prior to the
time in which
Q(t)= N/2, 4
is still
negative ge-0'
+
t,
is still
positive,
but 4
will,
if
yN
> a +
p/lnA(t),
be for some
period negative.
At the start of the
process,
those
properties
hold
except
that 4
may
start at either a
negative
or
positive
value. That
is, viewing
4
as a function of
time,
if
yN
> a +
P/
lnA
(t),
4
starts at t
=
0 with either a
positive
or
negative
value. It
goes
down and
becomes
(or remains) negative,
reaches a minimum and
begins
to climb until
it reaches zero at t. If
yN
< a +
f lnA(t),
then 4 starts
negative
and climbs
throughout
with a
positive
, (and
a
positive ge
-t +
4)
until it reaches zero at
t.
Throughout
this
process ge-
t
+ 4 remains
positive.
This last
property
implies
that the
Hamiltonian,
as
expressed by (10),
is a concave function of
A
(t).
Since the
constraining equations (9)
and
(11)
are also concave in A
(t),
the
optimization problem
has a
unique optimum.
The
optimal advertising policy
can be found based on the
necessary
condition
provided by
the maximum
principle
that
aH/aA
= 0. For the
problem
at hand:
aH
_
/[N-
Q(t)][ge
-?t +
1] -A(t)
-
=O.
(12)
From
(12)
we can determine
4,
obtain 4
by
its
differentiation,
and
equate
the
result to
4
of
(11).
This leads to
A
(t)
+
A(t){y[N
-
Q(t)]
-
0
+
OgP3[N- Q(t)]
=
0,
12
(13)
ADVERTISING AND THE DIFFUSION OF NEW PRODUCTS
which when solved
provides
the
optimal advertising policy
*A
(0)
=
Og/
[
9f~efi(T')
dtdT
-
11
A*(T)=-
A(0)
O
f
TfJo
+1
(14)
eJ
gT(t) d eoT('t) d
where
r(t)
=
y[N- Q*(t)]
-
0. The solution to differential
equation (9)
leads
to the
optimal path
of cumulative sales:
1 - yf
t)dtdT
Q*(T)=
N
{ - (
(15)
1
-
-yNfoTe
- f;;(t)
d,dT
where
'(t)
=
[a
+ f
lnA*(t)
+
yN]. Equations (14)
and
(15)
can be used to
solve for the
optimal
A
(T)
and
Q(T).
An actual
analytical
solution for A
*(T)
and
Q*(t)
as functions of time and
the different
parameterswould
be difficult to obtain
given
the
nonlinearity
of
equations (14)
and
(15);
nevertheless the characteristics of the
optimal
adver-
tising policy
and of the sales curve
accompanying
it can be determined.
Evaluation of
(13)
reveals that in the
beginning
if
yN
>
0,
then the second
term is
positive.
The third term is
always positive
and therefore A is
negative
and
A(t)
is a
decreasing
function over time. In
fact,
even if at that time
yN
<
0,
its effect
may
be canceled out
by
the third term which is
positive
such
that the sum of both terms be
positive.
Based on the
empirical
results
reported
earlier in this
paper
for our
study
as well as other
studies, yN
was
greater
than
reasonable values of 0.
Therefore,
an
optimal advertising policy
of
decreasing
A
(t)
at the start is
appropriate.
Once the
product
life
cycle proceeds,
it can be
shown that the
advertising outlay
should continue to fall. As has been
discussed earlier with
respect
to
(11), Ap
has a
negative
value either from the
start or
shortly afterwards,
and
certainly prior
to
Q(t) reaching
the value of
N/2. When
4,
is
negative,
it is clear from
(12)
that
8[N
-
Q(t)] ge-9'
>
A(t)e-0. (16)
Canceling
e-01 and
multiplying (16) through by
0 leads to
Ogp[N-
Q(t)]
>
OA(t). (17)
Inequality (17) implies
that the third term in
(13)
is
larger
than the
negative
component,
OA
(t),
of the second term. This
implies
that the sum of the second
and third terms is
positive, yielding
a
negative
A
(t)
from the time in which
4
becomes
negative.
In
fact,
even
earlier,
if
p
is
positive (17)
will be reversed but
its effects will for some
period
be canceled out
by
the
positive component
of
the second term of
(13), y[N
-
Q(T)].
Once
4,
becomes
negative,
it remains so
13
DAN HORSKY AND LEONARD S. SIMON
and therefore A
(t)
will be
negative
until the end of the
product
life
cycle.
Thus,
it has been demonstrated that the
optimal advertising policy
for most
new
products
will be to start with a
high advertising outlay
and reduce it
gradually
as the
product
moves
through
its life
cycle.
Ideally,
one would want to include
price
in
(8)
such that an
optimization
in
both
advertising
and
price
could be conducted. If in such a
joint optimization
the
policy
of
starting
with a
high advertising outlay
and
reducing
it over time
still
prevailed,
it would enhance the
generality
of this result. Since we did not
model nor test the
incorporation
of
price
into the diffusion
process,
such a
direct
joint optimization
cannot be conducted.
Nevertheless,
some indirect
support
can be
provided.
In the above
analysis
we have assumed that the
gross margin, g,
is a constant which does not
vary
in time. It is
empirically
known
(see,
for
example, Conley (The
Boston
Consulting Group, 1970))
that
both
components
of the
gross margin, price
and variable
costs,
decline over
time for durables.
Thus,
we have assumed so
far, probably unrealistically,
that
the difference between those two
components
remains
unchanged throughout.
If we assume more
realistically
based on the above evidence (and
the
likely
increase in
competitive pressure)
that the
gross margin gets
smaller over
time,
our above results for the
optimal advertising policy
can be shown to still hold.
In
(8)-(12),
g
will have to be
replaced by g(t).
The
manipulations
which
follow
(12)
and lead to
(13)
will result in the third term in
(13) being replaced
by [Og(t)
-
g(t)][N
-
Q(t)].
Since we assume that the
gross margin
reduces
over
time,
g(t)
is
always negative, resulting
in
Og(t)
-
g(t)
being always
positive.
This
implies
that the third term of
(13)
maintains its
property
of
being positive
and our
previous
result of
A(t) being negative
is
kept. Thus,
also in this case of a
decreasing gross margin
over
time,
the
policy
of a
decreasing advertising outlay
is
optimal.
The sales curve
resulting
from the use of the above
advertising policy
is best
evaluated
through
the first derivative of the sales function
S = [N
-
Q(t)]
A
+
[Ny-a-
-
nA(t)-2yQ(t)] Q (18)
A(t)
Examination of
(18)
reveals that the
peak
in sales will now occur earlier than
Q(t)
=
(N
-
a/y)/2 (which
would have been the
peak
if minimal
advertising
A
(t)
= 1 had been
used).
Further,
at
Q(t)
=
(N
-
a/y)/2
the
magnitude
of
sales is now
larger. Transforming
these observations from a
dependence
of
sales on
Q
to a
dependence
on time
implies
that the
peak
in sales will now
occur earlier and will be
higher.
Thus,
the
optimal advertising policy
and the
resulting
sales are
depicted
in
Figure
2. The
optimal
sales curve is contrasted
with the sales curve which would have occurred had a minimal
policy
of
A
(t)
= 1 been maintained.
The
optimal advertising policy depicted
in
Figure
2 is consistent with the
behavior of the banks we studied and with observed
practices
of other firms
introducing
new
products. Reports relating
to such a
policy
in consumer
goods
are
provided by
Buzzel
(1966)
and
(1978),
Cox
(1967),
and Lambin
14
ADVERTISING AND THE DIFFUSION OF NEW PRODUCTS
0
z
>L
\
A (T)
TIME
A (T)=A(T)
A (
T\A(T)=
I
TIME
FIGURE 2.
Optimal Advertising
and Sales.
(1976, pp. 124-127).
Similar
policies by producers
of
capital goods
are
reported by
Lilien and Little
(1976).
In
fact,
Lilien and Little
(1976) report
that,
while these
producers spend
much more on sales force than on advertis-
ing,
the
outlays
for both decline as the
products
mature. This is consistent with
our
previous
observation that for industrial
goods
the sales force effort should
be modeled
along
the same lines as
advertising.
As a
result,
in such
goods,
the
optimal policy
is to direct a lot of the sales force time to a new
product
when
it is
being
introduced and to reduce this effort
gradually
afterwards.
Summary
A model of new
product
diffusion which
incorporates advertising
as well as
word-of-mouth was
proposed
and validated
empirically.
It was demonstrated
that the firm could
control, through
the use of
advertising,
the distribution of
sales over time. The
optimal advertising policy
was derived and it was shown
that the firm should advertise
heavily
in the initial
periods, informing
all
innovators
early
about the existence of the new
product.
As these innovators
adopt
the
product
and turn into word-of-mouth
carriers,
the level of advertis-
ing
can be
gradually
reduced. Such a
policy
would cause the
peak
in sales to
be
higher
and to occur earlier than would have been the case if no
advertising
was used. This
advertising policy, apart
from
being
consistent with observed
policies
of
producers
of new
products,
also
highlights
the investment
aspects
of new
product
introductions. Prior to the actual
launching
of the new
product,
the firm has to invest
heavily
in research and
development
and in
15
DAN HORSKY AND LEONARD S. SIMON
production
facilities. In
addition, during
the
product's
introduction the firm
should,
based on our
results,
invest
heavily
in
advertising, prior
to
actually
obtaining
the level of sales revenues sufficient to cover such
outlays. However,
in later
periods
the firm will
reap
the benefits of the
goodwill advertising
has
created in the form of the
product's adopters.
In order for the model to be of even
greater
value to the
firm,
it would have
to be extended to treat the effects of
competition.
While a firm
may enjoy
a
monopolistic position
in the introduction
stage
of its new
product, competitors
will
eventually
enter. Potential
competition may
in fact be
enough
to force the
firm
(even though
it has
monopoly power
at the
introductory period)
to
behave as if
competition already
existed in the
introductory stage.
If
competi-
tion
exists,
then the effects of their
advertising strategies
should be
incorpo-
rated in the model and taken into account
by
the firm. A recent work
dealing
with
competitive advertising
in this context is Mate
(1980).
The
optimal policy
derived
numerically
there is also one of
decreasing advertising
over time.
Further,
the firm can
clearly
effect the diffusion
process through
its
pricing
policies.
The
development
of a
joint optimal policy
in both
advertising
and
price
should
certainly
be
sought. Finally,
other extensions could include
innovations of
product categories
in which
replacement
and
repeat purchasing
are
prevalent.5
5For an earlier work
regarding
the latter
topic,
see Haines
(1964).
As to
advertising
of
established
repeat purchase products,
this is a
well-developed area; see,
for
example,
Little
(1979)
for a review of such models and
Horsky (1977b)
for
optimal advertising policy implications.
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