Quality and Advertising in a Vertically Differentiated Market

We examine firms ’ quality positions when consumers can only consider purchasing prod-ucts that they are informed about through advertising. Consumers compare the alternatives in their consideration set and choose the product that maximizes their utility net of price. Firms choose product quality in a first stage, advertising strategy in a second stage, and prices in the last stage. We study two forms of advertising – blanket and targeted. Under blanket advertising, firms communicate indiscriminately and a consumer’s probability of see-ing an ad depends on the level of ad expenditure. We find that when blanket advertising is relatively ineffective, i.e., it is costly to ensure that all consumers are informed, both firms choose a light ad spending. This allows the firms to be relatively undifferentiated in qualities, without concern of intense price competition. When blanket advertising is very effective, the high quality firm expends heavily on advertising, while its rival differentiates with a low quality product and expends lightly on advertising. Interestingly, in a mid range of advertising effectiveness one firm chooses a high quality product and its rival positions close by. In this way, the lower quality firm induces its rival to advertise only lightly to avoi