Netnomics 1 (1999) 127–136 127

Economics of advertising: Emerging functions of Internet

advertising ∗
Marcus Ling a , Kevin Lawler a , Norman McBain a and Alfredo Moscardini b
a
Sunderland Business School, University of Sunderland, UK
E-mail: marcus.ling@sunderland.ac.uk
b
School of Computing and Information Systems, University of Sunderland,
Sunderland SR6 0DD, UK

This paper intends to highlight the emerging force of the Internet as an advertising
medium. The economic functions of Internet advertising are examined. Moreover, the
paper aims to evaluate the relative impacts on optimal advertising models. Our discussion
also includes analysis of associated price-cost margins with respect to optimal advertising
budgets and strategic reactions. All in all, this paper should provide entrepreneurs with
more crucial knowledge of advertising strategies offered by the new medium. Moreover,
it will equip scientists and technologists with more insights into the economic aspects and
strategic values of Internet advertising.

1. Introduction

Traditionally, mass media advertising has focused on TV and press advertising.

However, today Increased access to the use of the Internet means that electronic media
is fast becoming a dynamic user-friendly medium for advertising. Entrepreneurs, es-
pecially those involved in vigorous oligopolistic competition are always conscious of
the advertising strategies used by rivals. Historically, economists constructed models
which assessed the direct impacts on own-advertising expenditures as well as indi-
rect responses via rival advertising, to consider optimal advertising budgets. With
larger volumes of advertising space available on the Internet, the demand for desirable
advertised messages can now be more effectively satisfied. Moreover, the costs of set-
ting up a web site and locating information is relatively low compared to other mass
media channels. This introduces added economic value for advertisers/entrepreneurs.
However, growing involvement in electronic information may destabilise original ad-
vertising relationships upon which entrepreneurs have traditionally relied. This issue
constitutes the focal point of our investigation.
∗
Previous versions of this paper have been presented at the First Berlin Internet Economics Workshop in
Berlin in October 1997. The authors acknowledge helpful comments and suggestions from participants
in the Workshop in Berlin, but retain the sole responsibility for all imperfections.

 Baltzer Science Publishers BV

128 M. Ling et al. / Emerging functions of Internet advertising

Table 1
Total Internet advertising expenditure∗ .
$ million % increase
1996 Q1 29.9 –
Q2 51.9 73.6
Q3 75.6 45.7
Q4 109.5 44.8
1997 Q1 129.5 18.3
∗
Source: Internet Advertising Bureau.

2. Emerging forces

Recently the use of Internet advertising has been increasing; in 1996 Q4, for
example, total advertising expenditure on the WWW was estimated within the range
of $100 to $120 million. The estimate is expected to reach $1 billion per annum by the
end of the decade. According to the Internet Advertising Report 1997, a recent survey
indicates that the number of Internet users in the US now exceeds 51 million which
is a 46% increase on 1996 data. Moreover, Internet advertising in Japan is expected
to rocket to $32 million by 1997. So for 1997, compared to 1996 the Internet has
experienced a 25% increase in advertising volumes. This huge market potential is
also reflected by the rates of increase of aggregate advertising spending for the last
four quarters in 1996 (table 1). The rate of increase now seems to have declined in
the 1st quarter in 1997, due to the fact that current large absolute volume leaves less
room for a large percentage incremental increases. According to a survey complied by
the Internet Advertising Bureau (IAB), 45% of Internet publications suggest that the
expected revenue in 1997 is likely to be between $500 and $600 million world-wide.
Of course, with massive advertising expenditure flooding onto the Internet, publishers
are more than willing to reinvest for the development of WWW, making it more
attractive to both Internet users and advertisers1 . Eventually, this leads to cumulative
endogenous forces increasing the development of Internet advertising.
Internet advertising provides world-wide coverage of advertising messages which
attract advertisers aiming to extend market profiles. Nowadays much oligopoly rivalry
depends very much on heavy use of high profile advertising investment. Especially for
small companies, entry to a new market requires relatively huge efforts and budgets to
overcome existing preferences for dominant products/services. Kaldor [9] points out
that advertising may strengthen entry barriers. Schmalensee’s empirical work [21] fo-
cused on the US ready-to-eat cereal market, confirmed that advertising had restricted
new entrants during the sampling period 1950 to 19702 . In terms of market entry,
Internet advertising enables small budget companies to introduce products or services
1
It is believed that about 85% of Internet advertising revenue is shared by the top 25 Web sites. (Marketing
Week, December 13, 1996.)
2
Similarly, in Williamson’s [24] study, increase in advertising by existing firms leads to an increase in
market penetration barriers.
 M. Ling et al. / Emerging functions of Internet advertising 129

into new market more easily. However, the eventual market entry success depends
significantly on the popularity using Internet search in market places by target audi-
ences. The limitations of new market entry, if new players rely purely on Internet
marketing, is bounded by the level of superhighway infrastructure and the advance
of telecommunications in message receiving countries. For those markets with low
ratios of computer ownership, market share competition using Internet advertising is
restricted. Attitudes and social perceptions toward the use of computer network search
are also crucial for eventual success.
For particular industries, Internet advertising can assist the globalisation process.
Such activities include travel information agencies, hotel and catering activities, ser-
vice industries and others like banking, insurance and finance. Simply due to the
economies of scale obtained by large corporations, Internet advertising may provide
extra non-pecuniary benefits apart from raising sales revenue. These benefits may
consist of cost reductions such as, sales and distribution and other after-sale services,
centralised operational systems and informational advantages such as customer data
base collections and analysis. With the use of centralised and world-wide messages,
corporate images and missions can be standardised which is essential for effective
globalisation.

3. Economic functions

From economic viewpoint, advertising provides two major functions. One is per-
suasion, the other is of informational basis. To a very large extent, according to many
existing surveys complied by industry analysts, informative functions are of paramount
importance. Littlechild [16] suggests that advertising information is crucial in a world
of imperfect knowledge and uncertainty. Advertising provides valuable information for
consumers as they usually have limited data about all available rival products. Users
of interactive services, according to a CASIE (Coalition for Advertising Supported
Information and Entertainment) survey, about 60% of respondents carried out research
for information before final purchases, 72% of them sought educational information
and 54% searched for travel reservations and related information. The informative
economic function is even obvious in some activities such as transactions in foreign
exchange markets and property searches for estate agents. There has been a long
debate about the emerging role of Internet advertising which may possibly replace
middlemen in some salesforces. Moreover, broker-free transactions are very likely to
be the case for some financial sectors in future. Alongside these examples, Internet
advertising, embracing enhanced information-producing power, may foster the growth
of direct marketing industries3 . Moreover, Internet advertising provides personal one-
to-one communication myriad micro-segments. This is seldom the case in traditional
3
Rory Sutherland, head of Ogilvy and Mather Direct, felt that even Internet marketing is a narrow
medium, from the direct marketing point of view, and direct marketers are keen to participate. (Direct
Marketing, 11 July, 1996.)
130 M. Ling et al. / Emerging functions of Internet advertising

advertising mass media such as TV advertising or national newspaper advertising. The

ability of micro segmentation increases the search value for Internet users who look
for particular data relating to personal purchases.
The persuasive element of Internet advertising is reflected in the complex and
advanced design of banners. If Internet advertising does not offer a persuasive eco-
nomic function, no advertiser would wish spending increased sums designing attractive
banners or other high-tech images. Attractiveness is a crucial element persuading In-
ternet users to click-through an Internet advertisement. As an industry standard, the
click-through rate is now a widely accepted measure for evaluating Internet advertising
effectiveness4 . Persuasiveness also relies on the overall design and display. The Web
site – Infoseek, Internet Advertising Monograph, indicates that to attract users to click
on and to seek more information from an advertisement, a clear indication with “click
here” results in a much higher click-through rate, about 5 times higher than those
without this instruction. Moreover, a research finding indicates that banner advertis-
ing can increase brand awareness5 . Other marketing specialists claim that Internet
advertising helps products/services build brand identity6 . These forces contribute to
a change in consumer perceptions over other advertised products. Due to the per-
suasive impacts, advertising can result in increased product differentiation. Research
from Guth [8] demonstrated the significant effects of advertising on product differ-
entiation which eventually increased barriers to entry. All in all, the ultimate goal
of advertising is to distort buying habits and encourage consumption of advertised
brands.

4. Optimal advertising

Efficient use of firm specific assets is important to the long run survival. Even
though it is commonly accepted that advertising can foster sales, it does not follow that
firms ever need to increase advertising budgets. According to diminishing marginal
return principle, when advertising produces its maximum effect on sales, an additional
unit of advertising outlay may still increase sales revenue but at decreasing rates. This
can be called the diminishing returns to advertising outlays.
Hence, according to empirical findings, an inverted U-shaped curve for adver-
tising to profit ratio is often recorded. Figure 1 indicates the relationship between
advertising, profits and sales revenue with a profit constraint. As we move along
4
IAB is working actively to set guidelines to help any related agents compare on-line advertising per-
formance and traffic patterns. This ensures comparability exists in the Web sites’ advertising industry.
(Advertising Age, June 16, 1997.)
5
According to an IAB study carried out by MBinteractive, results of a sampling of 25,000 respondents
indicate that average awareness increases 5%. However, the best result from a new airline product
experienced an amazing 50% increase. (Advertising Age, June 16, 1997.)
6
Will Watson, media planner at Saatchi and Saatchi, who handles Toyota’s Internet advertising believes
that Internet games with rewards enable Toyota to build brand identity with players. (SMT, September
1996.)
 M. Ling et al. / Emerging functions of Internet advertising 131

Figure 1. Profit maximisation and revenue maximisation.

the horizontal axis from the left, initially an increase in advertising outlays results in
increased profits. To optimise the use of advertising resources with respect to profit
maximisation, a business should try to operate at E. If a firm carries out advertising
beyond point E, it suffers diminishing returns, leading to sub-optimal conditions. An
extra unit of adverting generates a less than proportionate increase in profits. Moreover,
profit maximising and revenue maximising firms have strategic differences in allocat-
ing advertising resources. In contrast to point E, revenue maximising firms tend to use
more advertising resources and set the optimal strategy at R. Consequently, under dif-
ferent business objectives, firms operate at different advertising allocations7 . Dorfman
and Steiner [6] established the pioneering theorem to investigate the linkages between
the optimum advertising and sales ratio. The landmark model of optimal advertising
is shown below.
A Ea
= , (1)
PQ Eq
where A = advertising outlay, P = price of product, Q = quantity of product,
Ea = advertising elasticity, Eq = price elasticity.
Equation (1) shows that optimal advertising to sales ratio is proportional to the
relative ratio of the advertising elasticities and price elasticities. The underlying reasons
are that since 1/Eq is equivalent to the Lerner Index [13], P − MC/P , where MC
stands for marginal cost of production. The numerator is named as the profit margin
and the index itself signifies the extent of market power. With an increase in marketing
power, it is more likely a business can raise price and the larger will be the optimum
7
The divergence between different optimisation strategies is closely related to the separation of ownership
and control. More details and evidence can be found in Sawyer [19, chapter 11].
132 M. Ling et al. / Emerging functions of Internet advertising

advertising level8 . This can be more easily seen if the Lerner Index is substituted into
equation (1) for the component 1/Eq . After the substitution, the equation is:
A (P − MC)Eq
= . (2)
PQ P
If Ea is greater than Eq , it is more likely that a company would raise price and
advertising expenditure to extract more market benefits. Typical cases of excessive
market power are often referred to as monopolies or, sometimes dominant oligopolised
firms. Schmalensee [20] pointed out that the greater the industry concentration, higher
profit rates and advertising to sales ratios result. For market share competition on
national scales, Dorfman–Steiner type models can be used properly to estimate the
strategic influences of advertising. As Internet advertising concerns global market
extensions rather than national sales, a model purely based on domestic market powers
to raise price could produce inconsistent pictures. However, if we utilise Dorfman–
Steiner type models and assume Internet advertising in the long run could allow firms
to accumulate market power across national boundaries, which is true for most of
the large globalised corporations, considerable impacts on long term profits (price
cost) margins could result. Based on the fact that Internet advertising includes vital
competitive functions, Internet advertising should be able to foster sales and equip
advertised brands with increased abilities to enjoy scale advantages. This, logically,
should affect the long run price cost difference, and in turn based on Dorfman–Steiner
type models, higher optimal scales of Internet advertising outlay should be observed.
At the moment, Internet advertising is still dominated by the traditional main-
stream advertising media. However, Internet advertising is attractive because of its cost
effectiveness. Moreover, it is very productive in terms of coverage and advertising
space. Based on the pros and cons of Internet advertising, placing an advertisement on
Internet should become vital element in future advertising campaigns. However, due to
the fact that the charge for Internet advertising compared with other traditional means
of advertising is rather low in most countries, the proportion of Internet advertising in
overall advertising budgets for most advertisers is still insignificant. This means that
the overall effect of Internet advertising on optimal allocations of advertising resources
is marginal. As technology evolves and Internet advertising becomes more dynamic,
the emerging force of Internet advertising may change this phenomenon. Of course, if
a company relies greatly on Internet advertising, both in terms of promotional scales
and budgetary levels, the Dorfman–Steiner type models should come into play.
Most marketers treat advertising as an expenditure item. Since continual adver-
tising has long run profit implications and produces strategic influences on competitive
advantages, advertising should be regarded as an investment item. Moreover, adver-
tising investment can be utilised to create income-generating stimuli such as image
improvements and brand-building. Therefore advertising should be treated as a firm-
8
Empirical findings from Comanor and Wilson [4] suggest that advertising can strengthen market power.
This concept was also stressed in the empirical work of Schmalensee [21] and discussions by Kaldor [9].
 M. Ling et al. / Emerging functions of Internet advertising 133

specific asset. Of course, from the consumer point of view, persuasive power takes
time to accumulate. Given time, if the brands fail to appear in the media, memories
of the brand fade away gradually. This implies that advertising influences erode with
the passage of time. Since these two contradictory forces of the medium’s influence
(accumulative and decaying) co-exist, continuous advertising investment is important
to ensure the long run survival9 .
Extending the Dorfman and Steiner theorem, Nerlove and Arrow [18] established
an optimal advertising model which treats advertising as a “goodwill” asset10 . The
model is
A Ea [1/(r + d)]
= , (3)
PQ Eq
where r = market rate of discounting, d = depreciation rate of advertising message.
The model basically follows Dorfman and Steiner theorem with two extra para-
meters, r and d. The decaying effect of advertising is captured by the parameter d
in the model. Evidence from empirical findings from Kioulafas [12], Griliches [7]
and Clark [3] shows that advertising produces a cumulative impact. They claim that
advertising effects prevail after the advertising time period but these also fade away in
time. The decay rate of Internet advertising, may be somewhat different from that of
traditional mass media advertising, which erodes more slowly. This is partly because
Internet users usually seek target brands and click on target advertisements. Most im-
portantly, the key aim of Internet search is in “active” mode. This helps fix persuasive
images and details of the informative content of the advertisement in the memory.
In contrast, mass media advertisers using TV may influence viewers in a relatively
passive way. Some viewers may have no intention to relate TV advertisements with
future consumption plans. Undoubtedly, TV advertising provides entertaining pictures
but it is not directly linked to any “active” consumption motives. So if a firm invests a
higher proportion of its advertising budget on Internet advertising and the decay rate is
comparatively smaller than in traditional media, a higher level of optimal advertising
outlay should be observed as compared to advertising campaigns dominated by tradi-
tional media. The reason is that advertising increases market power. This eventually
leads to stronger market positions and firms can capitalise greater profits by using
advertising as a stimulus. However, in an extreme case where an advertiser leaves the
Web site untouched forever, rational Web users have no desire wasting time to see
the same sets of information again and again. This demonstrates that effort put into
providing up-to-date advertised information is as equally important as that put into
persuasive designs and images. These two aspects determine the potential long run
impact offered by Internet searching.
9
According to Ling et al. [15], continuous advertising investment is of strategic importance and empirical
evidence indicates that continuous and systematic advertising allocations in the UK beer market create
statistically significant impacts on demand in the long run.
10
The concept of “goodwill” has been adopted by economists such as Schmalensee (1982), Shaprio [22]
and Kioulafas [12].
134 M. Ling et al. / Emerging functions of Internet advertising

Moreover, the decay rate can be also affected by the methods used to convey
messages and other taste factors. At the moment Internet users’ demographic data are
scant for most of advertisers. Therefore, the precise categorisation of target audiences,
targeting messages and designs for some products are virtually unknown. This is indeed
a disadvantageous factor compared to other advertising media. For instance, detailed
and organised consumer statistics can be gathered for different TV broadcasting time-
slots. Moreover, various professional magazines and special publications, to which
designated groups of readers of common interests are attached are available to calibrate
campaigns.

5. Strategic implications

Strategically speaking, the application of Internet advertising is in its infancy.

Hence, for some developed countries, market share competition has reached a rather
congested state and a new advertising medium like the Internet enables oligopolies to
consolidate business. This allows the economic functions of advertising campaigns to
be more widely seen and comprehensively executed. On the other hand, the emerging
popularity of Internet advertising may soften the competitive edge of dominant market
players with reference to entry barriers. This outcome is consistent with the concept
of contestable market theory and Neo-Austrian school who believe that long run entry
cannot be blocked. They believe competition is an on-going process and barriers
for potential entrants do not normally exist. In the traditional advertising battlefield, if
new firms want to enter markets, incumbent firms usually raise advertising to make the
prospect of gaining market share more costly. However, with relatively low costings,
intense action-retaliation via Internet advertising may become more viable11 . Rivals
can mimic the advertising trends of other market players more closely with less worry
about financial constraints. The rising trend for the use of Internet advertising can
be regarded as a classical case of the economic-technological diffusion process12 .
When a firm cares about the strategic moves of rivals, and if it notices more and
more rivals advertise on Internet, it may consider using Internet advertising more
seriously and the likelihood of advertising on Internet is increased as time goes by.
A lack of presence on the Internet may be fatal for a business in the long run13 . Even
for those businesses which are relatively ignorant of Internet usage or deficient in
investment in telecommunications and information technology, will consider improving
sale promotional systems. As Internet advertising becomes ever popular, the perceived
11
Ling et al. [15] show detailed discussion on strategic value of retaliatory advertising outlays by using
empirical data tested against Schmalensee model.
12
Mansfield’s [17] model of technological diffusion has been cited by many scholars. The structural link-
ages between modelling parameters was to go largely unchallenged for twenty years. The empirical
work indicated that the volume of technological diffusion concentrates mostly in the middle of the
adaptation period.
13
Rich LeFurgy, Director of Advertising at Starwave emphasises the importance of strategic thinking in
using Internet advertising. (Business Information Review, June 1996.)
 M. Ling et al. / Emerging functions of Internet advertising 135

Figure 2. Advertising “diffusion” with time.

risk of investment on the Internet reduces. As the time horizon increases, risk-averse
firms may also try to adopt the Internet. Consequently, Internet advertising volumes
are expected to increase which follows the basic tenet of economic diffusion. The long
run advertising trend is indicated by an S-curve in figure 2.
Some crucial points seem to map closely with developed and technological ad-
vanced countries. For those businesses situated in less developed countries or places
with low computer density, the scope of the impact of Internet advertising may be
reduced. This has given evidences of the unpopular use of direct marketing in China
and India, where the domestic sales cannot be stimulated by such a medium. However,
from promotional perspectives, if a company, say in China, wishes to extend its pres-
ence overseas, Internet advertising may enable the company to achieve this goal. As
a receiver country, Internet advertising can only activate limited effects. Ironically, as
a sender country, advertising messages reach other major markets in the USA, Japan
and EU. Therefore, the economic effectiveness of Internet advertising has dual effects
depending on whether the country is a receiver or a sender.

6. Conclusions

That the Internet will experience enhanced volumes of advertising traffic in the
next decade is obvious given the crude projections already made by analysts (table 1).
Crucially, the Internet will assist the development of emerging markets in the third
world and elsewhere. As a communication medium, the Internet is already made read-
ily available for use in former member states of the Old Soviet Union than traditional
telecommunications media. In time direct marketing will develop more via Internet
use. The functions of the Internet in terms of globalisation of activities is now obvious
too. Multi-national firms use the Internet already to provide product/services updates.
Hence the intensity of rivalry in the globalisation process will increase apace in the
next decade. Clearly it is the use of advertising strategies that the Internet will de-
velop in the next few years helping entrants and incumbents in globalised oligopolies
to increase advertising activity at lower real costs compared to the traditional meth-
ods of mass marketing. All in all consumers will benefit from greater product/service
136 M. Ling et al. / Emerging functions of Internet advertising

awareness. This will make markets more efficient where Internet use is widespread.
Enhanced advertising budgets for key players in the US, EU and the Far East will
occur as optimal advertising budgets are increased in scale to meet total changes in
sales revenue as advertising costs per message fall through time.

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