The Risk Reduction Role of Advertising

Abstract

This paper brings empirical evidence that the positive effect of exposure to advertising on consumers' tendency to purchase a product is due to the informative nature of ads and to consumers' risk-aversion. We show that the findings of previous studies that advertising intensity is an element in consumers' utility is due to the restrictive assumption that consumers are risk-neutral. When this assumption is relaxed, we find that exposure to advertising does not have any direct effect on the utility. Our model differs from the one presented by Erdem and Keane (1996), who did not allow advertising to have a direct effect on utility. Our model incorporates two channels through which advertising can have a positive effect on the purchase probability: (a) the risk reduction effect, and (b) a direct effect on the utility. We demonstrate, theoretically, how these two effects can be separated empirically. Furthermore, we show that the model that ignores one of these channels yields misleading estimates.

The findings (of previous studies) that the utility is a function of ad intensity have long disturbed scholars. It was interpreted as if consumers can be manipulated by ads. Advertising was accused of creating wants, distorting tastes and persuading consumers to buy products that they do not need. Our findings allay these concerns. Furthermore, we show that our approach can ameliorate advertising effectiveness, and assist practitioners in improving their advertising strategies.

Keywords: Advertising, information, uncertainty, risk aversion

JEL Classification: C51, D12, D80, L00, M37