This overview starts by giving a brief introduction to the economic theory of advertising, including a short presentation of the two main models of advertising and discussion of how advertising affects market outcomes in light of these two models. These theoretical underpinnings are then used to discuss the causes and potential effects of advertising in health care markets, with tentative implications for the social desirability of such advertising. A distinction is made between advertising of health care providers (hospitals or physicians) and advertising of prescription drugs, which are treated separately in this overview. Not only does drug advertising constitute the main bulk of total advertising expenditures in health care markets but it also involves some particular issues (and controversies) that demand separate attention.
The Economics Of Advertising
Advertising is a widespread feature of economic life and has been a major topic for economic research since the early twentieth century. This research has led to the emergence of two distinct and competing views about what advertising is, with very different implications about the effects – positive as well as normative – of advertising. We can think of these as two different models of advertising.
Informative Versus Persuasive Advertising
The informative advertising model takes as a starting point that most markets are characterized by asymmetric information, where consumers are ex ante imperfectly informed and need to search for information about products offered in the market. Because this search is costly, too few consumers will learn about the existence, price, and quality of products, causing market inefficiencies. According to the informative advertising model, advertising is a means to convey product information to consumers, which reduces consumers’ search costs and thus reduces the inefficiencies caused by asymmetric information.
The persuasive advertising model, however, has a very different starting point. According to this view, the main purpose and effect of advertising is to change consumers’ tastes and perceptions about the advertised product. Advertising is therefore a means to create ‘artificial’ product differentiation and brand loyalty, thereby increasing consumers’ willingness to pay for the product. Whereas informative advertising has a positive effect in terms of reducing information imperfections, the persuasive view arguably implies that advertising is socially wasteful because its main effect is to distort the ‘true’ preferences of consumers.
Effects Of Advertising
The informative and persuasive models of advertising predict very different effects of advertising, particularly with respect to competition and prices. Because real-life advertising rarely conforms to either of the two stylized models, but usually includes both persuasive and informative elements, an assessment of how advertising affects market outcomes, with corresponding implications for the social desirability of advertising, is a challenging exercise.
The main purpose of advertising is to increase demand for the advertised product. However, there are two sources of demand increases. Advertising could induce consumers to switch from a similar product offered by a competing firm toward the advertised one, or it could induce demand from new consumers who did not previously purchase any product from the market in question. The former is commonly referred to as business-stealing, whereas the latter is referred to as market expansion.
Advertising generally affects market prices. Theoretically, the price effects depend crucially on whether advertising is predominantly informative or persuasive. Informative advertising results in more consumers becoming aware of the existence and objective characteristics (including price) of available products. This makes demand more elastic (more price sensitive) and intensifies competition between competing brands, leading to lower prices in the market. However, persuasive advertising creates artificial product differentiation and brand loyalty, making consumers less willing to substitute between competing brands. This makes demand less elastic and allows firms to charge a higher price.
In many markets, with health care being a prime example, quality (rather than price) is a key characteristic of the products and services offered. Compared with the price effects, the effects of advertising on quality is theoretically less well established. If quality is observable and firms compete mainly on quality, informational advertising should lead to higher quality through increased competition.
However, quality is often not easily observable and it is therefore harder to assess to which extent advertising contains truthful information about quality. An important distinction can be made between search goods and experience goods. The quality of search goods can be ascertained before the purchase of the good, whereas the quality of experience goods can only be confirmed after the good is consumed. This suggests that producers of experience goods may have stronger incentives to advertise untruthfully about quality. However, in markets where consumers generally make repeated purchases, advertising in itself could function as a signal of high quality. Under the assumption that high-quality goods will be subject to more repeat purchases, producers of such goods will have incentives to advertise more to attract more first-time customers. This argument does not depend on the truthfulness of the advertising. Thus, seemingly persuasive advertising could have an informational value as a signal of high quality. However, the empirical evidence of a positive relationship between advertising and quality is mixed.
Advertising might also affect entry of new firms/products into the market. The potential entry-deterring effect of advertising is a much-researched topic. From a theoretical viewpoint, it is possible that persuasive advertising might deter entry by creating brand loyalty to incumbent firms’ products, implying that potential entrants would have to advertise more to capture these brand-loyal consumers, thereby increasing entry costs. However, there are also theoretical arguments suggesting that the optimal entry-deterring strategy is to underinvest in advertising. The key argument for this seemingly paradoxical result is that reducing the number of loyal consumers through lower advertising levels is a way for incumbent firms to commit themselves to higher output levels (or lower prices) in case of entry. Thus, incumbent firms might be able to deter entry by credibly committing themselves, through low pre-entry advertising levels, to become tough competitors post-entry. In either case, the empirical evidence of entry deterrence through advertising remains ambiguous.
Advertising Of Health Care Providers
Below, the basic economics concepts and theories of advertising outlined above are used to discuss advertising in health care markets specifically. The present section deals with advertising of health care providers (hospitals or physicians) while the subsequent section deals with drug advertising.
Why Do Health Care Providers Advertise?
Because advertising is a means to increase demand, health care providers have incentives to advertise only as long as they can increase demand. Thus, incentives for advertising essentially require that providers’ revenues are positively correlated with demand and that patients are able to choose their preferred provider. It is therefore no coincidence that health care advertising is mainly done by private health care providers. Traditionally, health care advertising has been more prevalent in the US, which has experienced health care advertising since the 1970s, particularly from for-profit providers. However, the introduction of market-based reforms in several European countries has made advertising relevant also for public (government-funded) health care providers, resulting, for example, in the lifting of the advertising ban on UK hospitals in 2008. In general, more competition in health care markets have been accompanied by a huge increase in advertising by health care providers (both hospitals and physicians) over the past couple of decades, although the advertising intensity in the health care sector remains as a relatively low fraction of total spending.
Is Heath Care Advertising Informative Or Persuasive?
An important characteristic of health care markets is the high degree of asymmetric information, in which providers have generally much more information than patients about the quality of the services offered. This makes informative advertising potentially more valuable as a means to reduce informational market imperfections. However, because health services are often complex and highly nonstandard products that make information harder to assess and compare, this arguably also increases the scope for persuasive advertising (for example, by using celebrities to endorse products or services). The slower consumers revise their beliefs about quality, the stronger the incentive to mislead consumers through persuasive advertising. However, as previously argued, even purely persuasive advertising might have informational value if it functions as a signal of quality. This argument is clearly applicable to health care services, which are better characterized as experience goods rather than search goods.
Although the empirical evidence is scant, there exists research indicating that physician advertising leads to higher prices, which suggests that such advertising is predominantly persuasive. However, this is clearly an under-researched topic in the health economics literature.
Direct-To-Consumer Advertising And The Role Of Physicians
A distinguishing feature of health care markets is that demand for health care is often a result of the interaction between patients and physicians, where, in most health care systems, general practitioners (GPs) act as gatekeepers to secondary health care (hospitals) through their referral decisions. Consequently, the effects of direct-to-consumer advertising (DTCA) must be analyzed and understood in the context of the physician–patient relationship.
DTCA can in principle have two different effects on demand; it can increase the number of patients seeking treatment for a particular condition and affect the choice of health care provider for patients seeking treatment. In health care systems that practice GP gatekeeping, the latter effect is determined by the patient–physician relationship. In a gatekeeping system, GPs provide information and affect patient choices. However, a more educated population arguably implies that patients play a more active role (vis-a` -vis the GP) in the process of choosing health care providers, and DTCA is an alternative source of information for patients.
If the GPs are well-informed perfect agents for patients, there is little or no role for positive effects of DTCA. In this case, the patient will only disagree with the GP’s recommendation if he is being misled by false advertising. However, GPs may not be perfect agents for their patients, either because GPs are not perfectly informed about available treatments or the two parties have different preferences with respect to the type of information they value. For example, GPs may care less about price information than patients do. Thus, to the extent that DTCA conveys accurate and relevant information to the patient, it may have positive effects in terms of reducing provider–patient mismatches if GPs are not perfectly informed or they do not always act in the best interest of the patient.
The above discussion ignores the potential effect of DTCA on the number of physician visits. A more thorough discussion of DTCA will be given in the context of drug advertising in the Section Advertising of Prescription Drugs, in which this is a more contentious issue.
Is Health Care Advertising Socially Wasteful?
If total demand for health care is relatively advertising inelastic, the effect of advertising is mainly business-stealing. This could improve the matching between patients and providers, but it could also imply a waste of resources, as a form of ‘medical arms race.’ This depends on the extent to which advertising works as an instrument to reduce information imperfections in the health care market. Informational advertising can also have a positive welfare effect if it lowers prices (or raises quality) through increased competition.
If advertising leads to a demand expansion, this could still be socially wasteful if this expansion is ‘artificially’ created by persuasive advertising, leading to overconsumption of health care. However, even persuasive advertising can have positive welfare effects if such advertising works as a reliable signal of quality, as discussed in the Section The Economics of Advertising.
Advertising Of Prescription Drugs
In contrast to health care providers (physician or hospitals), pharmaceutical companies spend a considerable share of revenues on advertising, often exceeding the share spent on research and development of new drugs.
With respect to advertising, there is a key distinction between prescription drugs and so-called over-the-counter (OTC) drugs. Because OTCs may be sold directly to consumers without a physician’s prescription, the natural advertising target is therefore consumers. For prescription drugs, by contrast, there are potentially two different advertising targets: consumers and physicians. Therefore, prescription drugs are advertised through two different channels: DTCA (if allowed) and physician detailing. In the following, the two different channels of prescription drug marketing will be discussed and compared.
Direct-To-Consumer Drug Advertising
In contrast to advertising of OTC drugs, DTCA of prescription drugs is currently banned in all developed countries, except in the USA and New Zealand, although steps towards liberalization have been taken in several countries. In the US, DTCA has been allowed since the 1980s, though subject to regulation. New and more liberal guidelines were adopted in 1997.
What are the main effects of direct-to-consumer drug advertising? There is little doubt that DTCA results in an increased total number of drug prescriptions, the most important contributing factor being that DTCA increases demand for physician consultations. Thus, in addition to direct advertising costs, there are considerable indirect costs of DTCA because of a higher number of physician consultations and more drug prescriptions. The extent to which these costs are outweighed by higher patient benefits depend on whether advertising-induced consultations are necessary or unnecessary, and whether advertising-induced prescriptions are cost-effective or not.
Like advertising of health care providers, direct-to-consumer drug advertising could also affect competition between pharmaceutical companies and thus drug prices. Drug advertising does not normally contain price information, but increased information about the existence of competing drug therapies may increase competition and lead to lower prices. Although DTCA is mainly undertaken by patent-holding firms, these are seldom pure monopolies due to the existence of therapeutic substitutes in many submarkets.
The contentious nature of DTCA of prescription drugs, reflected in the widespread ban on such activities, requires a more thorough discussion of the relevant arguments.
A main argument in favor of DTCA is that it contributes to consumer education by increasing awareness of alternative drug treatments. This is the standard informative advertising viewpoint, and the validity of this argument clearly relies on the informational content of DTCA. However, another important side-effect of DTCA is that information about alternative drug treatments may also increase consumer awareness about the underlying medical conditions, thus increasing the likelihood that potentially serious diseases are detected at an earlier stage.
Besides the potential for reducing informational inefficiencies, DTCA arguably also promotes greater patient autonomy by motivating patients to play a more active role in their treatment. One could also argue that DTCA works to counterbalance the effect of physician detailing. If persuasive drug detailing towards physicians leads to a distortion of prescription choices, this could partly be corrected by making patients better informed about alternative drug treatments through DTCA.
However, several arguments have been put forward against allowing DTCA of prescription drugs. Although DTCA has the potential to reduce inefficiencies caused by imperfect information on the demand side of the market, this requires that consumers are equipped with sufficient background knowledge to understand and properly evaluate the information given by DTCA. If this is not the case, DTCA might lead consumers to demand drug treatment against medical conditions that are either nonexistent or better left untreated. Thus, DTCA might induce overconsumption of drugs and encourage the use of unnecessary medication. Similarly, DTCA might also contribute to overmedication by creating a bias in favor of drug treatment instead of nonpharmacological interventions, such as lifestyle changes.
Although DTCA can have positive effects in terms of promoting greater patient autonomy, there is also a potential flip side. If DTCA has mainly a persuasive, rather than an informative effect, this might introduce more costs and strains in the physician–patient relationship, in which physicians have to spend more time correcting misinformed views because of DTCA. Physicians might also face increased pressure from patients to prescribe new and less-well tested drugs.
DTCA Versus Physician Detailing
Although DTCA is banned in most countries, advertising targeted towards physicians – so called detailing – is generally allowed (though regulated). Indeed, physician detailing constitutes the main share of total drug marketing expenditures. This form of drug marketing includes visits by sales representatives to physicians, as well as advertising in medical journals. Because face-to-face advertising is more costly, the likely impact on prescription choices is also higher.
Like DTCA, physician detailing can, in principle, have both market-expanding and business-stealing effects. It has a market-expanding effect if it increases physicians’ propensity to choose drug treatment over nonpharmacological treatments, and it has a business-stealing effect if it affects physicians’ propensity to prescribe drug treatment A over drug treatment B. Like other types of advertising, detailing can reduce informational inefficiencies and improve the matches between medical conditions and drug treatments, if the informational content of this type of marketing is sufficiently high. However, it would be naive to disregard the possibility that there is also a substantial persuasive element to physician detailing. In fact, empirical studies showing that detailing reduces the price elasticity of demand suggest the existence of a significant persuasive effect.
An interesting question is whether DTCA and physician detailing are complement or substitute marketing strategies for pharmaceutical companies. Although detailing clearly affects prescription choices, empirical evidence suggests that DTCA has a larger effect on physician visits than on prescription choices, implying that DTCA mainly has a market-expanding effect. If the effect of detailing is mainly business stealing, while the effect of DTCA is mainly market expansion, this suggests that detailing and DTCA are complement strategies: More DTCA leads to a higher number of physician visits, which increases the profitability of spending resources on physician detailing to influence prescription choices.
Thus, if DTCA and physician detailing are complement strategies, an unintended side-effect of allowing DTCA is that it would lead to increased levels of physician detailing as well.
Drug Advertising And Generic Competition
A major concern for policy makers and regulators of pharmaceutical markets is to ensure that competition in the off-patent market is sufficiently stimulated. An important question in this respect is how advertising affects competition in the off-patent market. More specifically, how does advertising affect the probability of generic entry and how does it affect price competition between brand name and generic drugs?
A robust empirical regularity in the off-patent market for prescription drugs is that brand name drugs are consistently priced higher than their generic versions. Some early empirical studies even found that brand name prices tended to increase after generic entry. From an economics perspective, the persistent positive price difference between brand name and generic drugs is somewhat puzzling, as competition between homogeneous products (brand names and their generic versions) should be expected to lead to fierce price competition with uniformly low drug prices as a result. This strongly suggests that brand name and generic drugs are vertically differentiated in the eyes of consumers (or prescribing physicians), where brand name drugs are somehow perceived to be of higher quality. The most prominent theoretical explanation for the price difference between brand names and generics is that it is a result of persuasive advertising of the brand name drug during the patent period, creating a brand-loyalty that allows for brand-name drugs to be charged a higher price than its generic alternatives after patent expiry. Given that brandname and generic drug versions have, by definition, identical active chemical ingredients and absorption rates, the observed price difference is a strong indicator of a significant persuasive element in drug advertising, which is usually considered to be detrimental for welfare.
The vertical differentiation created by brand-name drug advertising relaxes price competition in the off-patent market and allows for higher prices, not only of the brand-name drugs but also of the generic competitors. This suggests that brandname drug advertising has potentially two counteracting effects on generic entry. On the one hand, persuasive advertising creates brand-loyalty that, all else being equal, reduces demand for generics and makes generic entry less profitable. However, such advertising creates ‘artificial’ vertical differentiation and relaxes price competition, which, all else being equal, makes generic entry more profitable. The second effect is more likely to dominate if advertising also has a market expanding effect, which allows for generally higher drug prices in the market.
Whether advertising stimulates or deters generic entry (i.e., which of the two mentioned effects dominates) depends crucially on the strictness of price regulation in the off-patent market. If price regulation is very strict, advertising leads to brand-loyalty without a corresponding increase in prices. In this case, advertising is likely to have an entry-deterring effect. However, the price competition effect might dominate if price regulation in the off-patent market is absent or sufficiently lax.
The above reasoning implies that even purely persuasive advertising might have positive welfare effects if it induces generic entry after patent expiration. Persuasive advertising relaxes price competition by creating artificial vertical differentiation, but this might also induce generic entry that would otherwise have been deterred because of strong price competition (in the absence of advertising).
Notice that the above discussion implies that, to the extent that brand-name drug producers can deter entry through advertising, the nature of the optimal entry-deterring strategy is a priori ambiguous. Patent-holding firms might overinvest in advertising in order to build up brand-loyalty and thereby make generic entry less profitable. However, because advertising may partly benefit generic entrants, through market expansion and relaxed price competition, the optimal entry deterring strategy might instead be to underinvest in advertising.
Finally, although the results are somewhat mixed and inconclusive, the empirical literature on strategic entry deterrence in pharmaceutical markets does not seem to produce very strong evidence that brand name advertising deters entry.
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