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This paper examines the effects of advertising on the sales growth of new products. It is assumed that producer originated advertising serves to inform innovators of the existence and value 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.
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Dan Horsky and Leonard S. Simon - Advertising and the Diffusion of New Products
This paper examines the effects of advertising on the sales growth of new products. It is assumed that producer originated advertising serves to inform innovators of the existence and value 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.
This paper examines the effects of advertising on the sales growth of new products. It is assumed that producer originated advertising serves to inform innovators of the existence and value 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.
Reviewed work(s): Source: Marketing Science, Vol. 2, No. 1 (Winter, 1983), pp. 1-17 Published by: INFORMS Stable URL: http://www.jstor.org/stable/184065 . Accessed: 29/11/2011 10:15 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. INFORMS is collaborating with JSTOR to digitize, preserve and extend access to Marketing Science. http://www.jstor.org 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). 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