Does advertising help or harm the economy?

November 27, 2012

It's impossible to escape advertising. Truck ads on billboards, beer ads on television, pop-up ads for credit cards on the Internet. It's everywhere. Last year, U.S. companies spent about $144 billion on commercials and other forms of marketing—about 1 percent of the GDP. So what effect do all these ads have on the economy?


Hmm... Maybe this isn't overkill after all? (AP)

Economists have been debating this topic for a century now, and a couple of broad camps have formed. Many argue that ads are ultimately beneficial, giving people more information about products and boosting competition. Others suggest that ads are essentially a psychological ploy, persuading people to buy things they wouldn't otherwise want or need. And a few economists, notably Arthur Pigou, have argued that there's too much advertising in the world, with rival companies merely bludgeoning each other to a standstill.

So which view is correct? Over at VoxEU, Ferdinand Rauch of the University of Oxford describes a fascinating natural experiment he studied to shed light on this question. It turns out that many camps are correct. Advertising does appear to make some products cheaper on the whole—presumably because the ads are informative. But for other products like alcohol or restaurants, ads do seem to persuade people to buy more than they otherwise would.

In his recent paper (pdf), Rauch examined Austria, which has eight regions that all once taxed advertising at different rates. Then, in 2000, the central government stepped in to harmonize this tax across the entire country, setting it at a flat 5 percent. That meant the advertising tax went up in some regions and down in others.

This change, Rauch notes, had an immediate and large impact on the amount of advertising in each region. In other words, an ad tax really does discourage ads.


Change in advertising costs after Austria harmonized its ad tax in 2000.

The change in advertising seemed to have a noticeable impact on consumer prices in Austria. In some areas, prices actually went up as the amount of advertising on these products increased. That suggests that the ads were convincing people to buy more of these products than they otherwise would. 

But in other areas, such as food and education, prices went down as more ads appeared. This seems to suggest that ads were giving people better information about products and allowing them to make more discerning choices. (Indeed, Rauch found that the types of ads in industries where prices went down tended to be more informative.) 

Now, obviously in many areas ads are both informative and persuasive, in which case it's difficult to untangle the effect on prices. But on the whole, Rauch found that advertising tends to lower consumer prices across the board. If Austria's 5 percent tax on ads were repealed entirely, he estimated, consumer prices would decrease about 0.25 percentage points on average—though it would vary from industry to industry.

This isn't a totally theoretical argument. Over the years, a few U.S. states have considered taxing ads. The Florida legislature passed such a tax in 1987, though it was repealed six months later after an outcry. In 2006, Pennsylvania mulled a 6 percent sales tax on advertising. And France has occasionally flirted with the idea.

The merits of this idea depend a lot on whether advertising does more harm than good. And, as economist Timothy Taylor sums up, "Advertising may be that rare case where economists are less cynical than the general public."

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Neil Irwin | November 27, 2012