Up to this point, we have assumed that products are differentiated in a way that corresponds to some real desire of consumers. There is real convenience in having a gas station in your neighbourhood; Chinese food and Mexican food are really different from each other.

In the real world, however, some instances of product differentiation can seem puzzling if you think about them. What is the real difference between Crest and Colgate toothpaste? Between Energizer and Duracell batteries? Or a Marriott and a Hilton hotel room? Most people would be hard-pressed to answer any of these questions. Yet the producers of these goods make considerable efforts to convince consumers that their products are different from and better than those of their competitors.

No discussion of product differentiation is complete without spending at least a bit of time on the two related issues—and puzzles—of advertising and brand names.

Wheat farmers don’t advertise their wares on TV, but car dealers do. That’s not because farmers are shy and car dealers are outgoing; it’s because advertising is worthwhile only in industries in which firms have at least some market power.

The purpose of advertisements is to convince people to buy more of a seller’s product at the going price. A perfectly competitive firm, which can sell as much as it likes at the going market price, has no incentive to spend money convincing consumers to buy more. Only a firm that has some market power, and that therefore charges a price above marginal cost, can gain from advertising. (Industries that are more or less perfectly competitive, like the milk industry, do advertise—but these ads are sponsored by an association such as a provincial milk marketing board on behalf of the industry, not on behalf of the milk that comes from the cows on a particular farm.)

Given that advertising “works,” it’s not hard to see why firms with market power would spend money on it. But the big question about advertising is why it works. A related question is whether advertising is, from society’s point of view, a waste of resources.

Not all advertising poses a puzzle. Much of it is straightforward: it’s a way for sellers to inform potential buyers about what they have to offer (or, occasionally, for buyers to inform potential sellers about what they want). Nor is there much controversy about the economic usefulness of ads that provide information: the real estate ad that declares “sunny, charming, 2 br, 1 ba, a/c” tells you things you need to know (even if a few euphemisms are involved—“charming,” of course, means “small”).

Fortunately, someone is looking out for consumers: providing misleading information in ads violates the Competition Act. For example, in 2012 the Competition Bureau sued Bell Canada, Rogers, Telus, and the Canadian Wireless Telecommunications Association (CWTA) for misleading advertising. The investigation concluded that customers were given the false impression that certain texts and apps were free of charge, but these services were later charged to them. The Competition Bureau sought full refunds for customers and imposed $31 million in penalties ($10 million for each of the telecommunication companies involved and $1 million for the CWTA).

But if ads must be honest, what information is being conveyed when a TV actress proclaims the virtues of one or another toothpaste or a sports hero declares that some company’s batteries are better than those inside that pink mechanical rabbit? Surely nobody believes that the sports star is an expert on batteries—or that he chose the company that he personally believes makes the best batteries, as opposed to the company that offered to pay him the most. Yet companies believe, with good reason, that money spent on such promotions increases their sales—and that they would be in big trouble if they stopped advertising but their competitors continued to do so.

Why are consumers influenced by ads that do not really provide any information about the product? One answer is that consumers are not as rational as economists typically assume. Perhaps consumers’ judgments, or even their tastes, can be influenced by things that economists think ought to be irrelevant, such as which company has hired the most charismatic celebrity to endorse its product. And there is surely some truth to this. As we learned in Chapter 9, consumer rationality is a useful working assumption; it is not an absolute truth.

However, another answer is that consumer response to advertising is not entirely irrational because ads can serve as indirect “signals” in a world where consumers don’t have good information about products. Suppose, to take a common example, that you need to avail yourself of some local service that you don’t use regularly—body work on your car, say, or furniture moving. You turn to the Yellow Pages or search online, where you see a number of small listings and several large display, or featured, ads. You know that firms pay extra for the larger ads; still, it may be quite rational to contact one of the firms with a big ad. After all, the big ad probably means that it’s a relatively large, successful company—otherwise, the company wouldn’t have found it worth spending the money for the larger ad.

The same principle may partly explain why ads feature celebrities. You don’t really believe that the supermodel prefers that watch; but the fact that the watch manufacturer is willing and able to pay her fee tells you that it is a major company that is likely to stand behind its product. According to this reasoning, an expensive advertisement serves to establish the quality of a firm’s products in the eyes of consumers.

The possibility that it is rational for consumers to respond to advertising also has some bearing on the question of whether advertising is a waste of resources. If ads only work by manipulating the weak-minded, the $14 billion that Canadian businesses spent on advertising (and the $29 billion on marketing-related activities) in 2011 would have been an economic waste—except to the extent that ads sometimes provide entertainment. However, to the extent that advertising conveys important information, it is an economically productive activity after all.

You’ve been driving all day, and you decide that it’s time to find a place to sleep. On your right, you see a sign for the Bates Motel; on your left, you see a sign for a Travelodge, or a Best Western, or some other national chain. Which one do you choose?

Unless they were familiar with the area, most people would head for the chain. In fact, most motels in Canada are members of major chains; the same is true of most fast-food restaurants and many, if not most, stores in shopping malls.

Motel chains and fast-food restaurants are only one aspect of a broader phenomenon: the role of brand names, names owned by particular companies that differentiate their products in the minds of consumers. In many cases, a company’s brand name is the most important asset it possesses: clearly, Tim Hortons is worth far more than the sum of the coffee and baking equipment the company owns.

In fact, companies often go to considerable lengths to defend their brand names, suing anyone else who uses them without permission. You may talk about blowing your nose on a kleenex or googling a person, but legally only Kleenex can call its facial tissue “Kleenex” and only Google can call its search engine “Google.”

As with advertising, with which they are closely linked, the social usefulness of brand names is a source of dispute. Does the preference of consumers for known brands reflect consumer irrationality? Or do brand names convey real information? That is, do brand names create unnecessary market power, or do they serve a real purpose?

As in the case of advertising, the answer is probably some of both. On one side, brand names often do create unjustified market power. Many consumers will pay more for brand-name goods in the supermarket even though consumer experts assure us that the cheaper store brands are equally good. Similarly, many common medicines, like acetylsalicylic acid (ASA, the key ingredient in Aspirin), are cheaper—with no loss of quality—in their generic form.

On the other side, for many products the brand name does convey information. A traveller arriving in a strange town can be sure of what awaits in a Holiday Inn or a Tim Hortons; a tired and hungry traveller may find these standardized products preferable to trying an independent hotel or restaurant that might be better—but might be worse.

In addition, brand names offer some assurance that the seller is engaged in repeated interaction with its customers and so has a reputation to protect. If a traveller eats a bad meal at a restaurant in a tourist trap and vows never to eat there again, the restaurant owner may not care, since the chance is small that the traveller will be in the same area again in the future. But if that traveller eats a bad meal at Tim Hortons and vows never to eat at a Tim Hortons again, that matters to the company. This gives Tim Hortons an incentive to provide consistent quality, thereby assuring travellers that quality controls are in place.