Advertising in Vertical Relationships: An Equilibrium Model of the Automobile Industry

I model consumer demand for new cars, and pricing and advertising decisions of automobile manufacturers and dealers. I estimate the model with detailed car transaction and local advertising data, and I recover consumer preferences and firm surplus. On the demand side, the consumer purchase decision depends on the distance between dealers and consumers and advertising spending by both dealers and manufacturers. On the supply side, both dealers and manufacturers make a price-cost markup which is the result of a double marginalization pricing externality, and there is a public goods advertising externality. Advertising is under-provided from the perspective of total vertical surplus compared to the optimal decisions of an integrated vertical structure. I recover manufacturer and dealer surplus in a similar way to the previous literature that only models pricing decisions of firms. Dealer and manufacturer surplus depends not only on price-cost markups, but also on advertising spending. I find that dealers earn 8% more surplus on average than manufacturers, in contrast to about 16% more in a specification without advertising decisions.

The automobile dealer-manufacturer relationship is highly regulated by U.S. states. I use the estimation results to predict how dealer and manufacturer decisions would change after changes to two dealer franchise regulations. In a first counterfactual, I find that if a dealer-manufacturer pair is allowed to coordinate decisions, advertising more than doubles and prices fall by 15% on average for the coordinated firm. However, the average price falls by 20% if advertising is held constant. In a second counterfactual, I simulate the effect of forced dealer exit. Brand advertising falls substantially, which harms the remaining dealers, even though they face less competition.