A model of vertical differentiation, brand loyalty, and persuasive advertising

In this paper, we analyze the impact of advertising and quality decisions on price competition in a duopoly setting. Firms are able to differentiate their products vertically and use persuasive advertising to increase consumer brand loyalty. The model predicts that the high quality firm will advertise more intensively than the low quality firm in both covered and uncovered markets. Because consumers are assumed to be informed about product characteristics, advertising neither signals high quality nor discourages firms from lowering product quality unexpectedly. Instead, advertising is persuasive and is used to dampen price competition, enabling firms to avoid the Bertrand Paradox. This model provides one explanation for the coexistence of name (heavily advertised) and generic (sparsely advertised) brands.

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