1

Conclusion

An Empirical Study of the

Dynamics of Brand Building
Ron N. Borkovsky

Avi Goldfarb

Sridhar Moorthy1

Avery Haviv

Rotman School of Management, University of Toronto

January 13, 2013

PRELIMINARY.

Abstract
Brand equity offers long-term benefits that are built over time. Therefore, brand equity is an inherently
dynamic process. In this paper, we explore this dynamic process through a model of brand building and
harvesting, in which firms invest in advertising in order to build and sustain brand equity. The model
allows us to address several fundamental questions on the nature of brand-building and competition:
How strong are the leading firms incentives to perpetuate its brand equity advantage? How strong are
the followers incentives to overcome the gap it faces? When should firms harvest brands? How efficient
is the conversion of advertising into brand equity and how quickly does brand equity depreciate? The
model also enables a dynamic measure of the value of a brand to a firm that accounts for the effect of
the brand on both current and future profits. We estimate this model using data from the stacked chips
category in the consumer packaged goods (CPG) industry. The stacked potato chip market is ideally
suited for this study because it is a duopoly that focuses a great deal on brand equity, displays interesting
brand equity dynamics over time, and is characterized by very high levels of spending on advertising.

1.

ron.borkovsky@rotman.utoronto.ca,

sridhar.moorthy@rotman.utoronto.ca

avi.goldfarb@rotman.utoronto.ca,

avery.haviv09@rotman.utoronto.ca,

Section 1

1 Introduction
Brand equity is perhaps the single most important asset that marketing contributes to a firm. Strong brand
equity can generate awareness among consumers, induce repeat purchasing, and serve as a promise of high
quality. It is widely recognized that brand equity is a dynamic concept because firms must invest in both
building and sustaining it (Keller 1997, Ataman, Mela & van Heerde 2008, Erdem, Keane & Sun 2008).
Furthermore, brand equity delivers long-term benefits because it is not instantly depleted. However, thus
far little work has been done to explore brand strategy in a dynamic context. The purpose of this research
is to better understand brand building and harvesting and, accordingly, the evolution of brand equity in
oligopolistic industries. To this end, we build on the static structural approach to measuring the value of a
brand2 proposed in Goldfarb, Lu & Moorthy (2009) and apply the Pakes & McGuire (1994) quality ladder
model to the concept of brand equity. We estimate the model using data from the stacked potato chips
market.
Specifically, we build and estimate a dynamic model of brand building in which firms invest in advertising
and other promotional activities in order to build and sustain brand equity. The dynamic model is necessary
to address several fundamental questions on the nature of brand value, brand-building, and competition:
How strong are the leading firms incentives to perpetuate its brand equity advantage? How strong are the
followers incentives to overcome the gap it faces? When should firms harvest brands? How efficient is the
conversion of advertising into brand equity and how quickly does brand equity depreciate? In addition to
helping to answer these questions, the model and estimation process also provide a new tool that can be
used to measure brand value in a dynamic equilibrium context, providing a more complete measure of the
value of a brand as an intangible asset.
We estimate this model using data from the stacked potato chip market in the consumer packaged goods
(CPG) industry. The stacked potato chip market is ideally suited for this study because it is a duopoly
that focuses a great deal on brand equity, displays interesting brand equity dynamics over time, has readily
available data on prices, advertising, and market shares, and is characterized by high levels of spending on
advertising.
We feel that the results of our estimation help us to better understand brand value and brand building in
a dynamic context. We find that in the stacked chips category, brand equity has the potential to increase the
value of a product by up to $1.29 billion. We find that STAX entry caused the value of the Pringles brand to
decrease. Moreover, we find that the competition that STAX entry induced in the category caused the value
2. Consistent with the prior literature, we define brand value as the value of a brand to a firm, whereas brand equity is the
value of a brand to consumers.

Literature Review

of both the Pringles and STAX brands to decrease. In particular, from the third quarter of 2003the quarter
before STAX enteredto the second quarter of 2006, the Pringles brand decreased in value by $118.04 million.
From the fourth quarter of 2003the quarter in which STAX enteredto the second quarter of 2006, the STAX
brand decreased in value by $96.99 million. We are also able to learn several interesting things about the ways
in which firms build brands in the stacked chips category. First, a firm invests most heavily in advertising
when it has intermediate brand equity and its rivals brand equity is low.

Second, a firms advertising

spending is increasing in its own brand equity (up to a threshold) and decreasing in its rivals brand equity.
Finally, we find that despite Pringles early brand equity advantage, STAX is likely to ultimately catch up
to it and, therefore, the likely long-run market structure in the stacked chips category is symmetric.
This paper also contributes to the methodological literature by estimating, rather than calibrating, the
Pakes & McGuire (1994) quality ladder model in a computationally feasible way. Our specification allows
for greater variability in the outcomes of firms in the market by introducing firm-specific shocks to marginal
cost and advertising effectiveness.
The paper proceeds as follows. In section 2, we discuss the relevant literature and our contribution to
it. In section 3, we discuss the data that we use to estimate the model. In section 4, we present the static
model of price competition and discuss our approach to estimating the model. We also discuss the results
that the estimation yieldsin particular, quarterly estimates of the brand equities for Pringles and STAX
respectively and an estimate of the period profit function, which are treated as primitives in the dynamic
model. In section 5, we present the dynamic model of brand building and discuss our estimation strategy. In
section 6, we discuss the estimated equilibrium of the dynamic model and present results. Section 7 presents
counterfactuals that explore the effect of changes in industry fundamentals on brand building incentives, the
evolution of brand equity, and accordingly brand value.

2 Literature Review
This paper contributes to the literatures on (i) measuring brand value, (ii) brand equity dynamics, (iii)
dynamic models of advertising, and (iv) estimation and calibration of dynamic oligopoly models. Below, we
discuss these literatures and this papers contributions to them.

2.1 Measuring Brand Value

The long literature on brand value measurement has its origins in Rosen (1974) and Holbrook (1992). These
earlier approaches involved static reduced-form methods such as hedonic regression to estimate brand equity

Section 2

as a price premium after controlling for various non-brand factors. Ailawadi, Lehmann & Neslins (2003)
revenue premium method calculates brand value as the difference between brand revenues and private
label revenues. Building on Ailawadi, Lehmann & Neslin (2003), Goldfarb, Lu & Moorthy (2009) make
two contributions. First, they measure brand value in terms of profit contribution as opposed to revenue
contribution or price premium. They do so by comparing the equilibrium profit earned by a brand and
the profit earned in a counterfactual equilibrium where the brand has "lost" its brand equity but retained
its search attributes. Second, their structural approach accounts for the effect of brand equity on both
the demand side - i.e., on consumers brand choices - and on the supply side - i.e., on manufacturer and
retailer pricing decisions. Ferjani, Jedidi, and Jagpal (2009) estimate brand value by combining conjointbased demand estimation with Goldfarb, Lu, and Moorthys (2009) equilibrium framework. The addition
of conjoint analysis enables a richer understanding of the role of specific search and experience attributes
in driving brand value. Our dynamic model complements these approaches by incorporating the long term
effects of brand equity into an estimator of brand value.

2.2 Brand Equity Dynamics

Brand equity dynamics have not yet been studied extensively. Simon & Sullivan (1993) do so implicitly by
conducting event studies that explore the effects of various marketing decisions on the brand equities of Coke
and Pepsi. They find that a Coke brand extension enhanced its brand equity and reduced Pepsis brand
equity; that both firms enhanced their brand equities through simultaneous reformulations; and that a failed
reformulation attempt by Coke reduced its own brand equity and enhanced Pepsis brand equity. Sriram,
Balachander & Kalwani (2007) estimate static brand equity measures and then examine how changes in
advertising, sales promotion, and product innovation correlate with changes in brand equity. In the categories
they study (toothpaste and dish detergent) they find that advertising and product innovation enhance brand
equity. In comprehensive surveys of the academic branding literature, Ailawadi, Lehmann & Neslin (2003)
and Keller & Lehmann (2006) raise several important questions on the dynamics of brand equity. How does
brand equity evolve over time? How does brand equity evolve in the face of competition? Furthermore, as
much of the benefit of a brand to a firm comes from its future potential, how can one quantify the long-term
financial value of a brand? Finally, as a brands equity arises as the outcome of the equilibrium marketing
decisions made by a parent firm and its rivals, how can one estimate these relationships so as to understand
the very process by which firms firms develop high equity brands? Our model is specifically designed to
address many of these questions. As we show below, equilibrium dynamics in oligopolistic industries can
lead to surprising results on equilibrium returns to brand equity investments.

Literature Review

2.3 Dynamic Models of Advertising

There is a long history of academic research on dynamic models of advertising. In a seminal paper, Nerlove
& Arrow (1962) characterize the optimal advertising policy of a single forward-looking firm that invests
in advertising in order to build a stock of goodwill. Horsky (1977) extends this model by incorporating
market rivals. However, as the model is solved as an optimal control problem, it does not capture strategic
interaction between firms. Several later papers incorporate strategic interaction by studying duopolistic
advertising competition in the context of a differential game (e.g. Rao 1984, Chintagunta & Vilcassim
1992); see Jorgensen (1982) and Rao (1990) for literature reviews. While differential games contributed
greatly to the advancement of this literature, they do have some limitations. First, they are quite stylized e.g., they do not include a model of sales, but rather simply an exogenous differential equation that reflects
how market structure responds to advertising. Second, it is difficult to incorporate more than two firms.
Two relatively recent papers have studied advertising dynamics using more flexible models of oligopolistic
competition devised in the Ericson & Pakes (1995) framework: Dub, Hitsch & Manchanda (2005) explore
whether pulsing should arise in equilibrium. Doraszelski & Markovich (2007) contrast models of goodwill
and awareness advertising and assesses whether advertising can lead to a sustainable competitive advantage.
Many of the papers cited above estimate how sales and market shares respond to advertising (Horksy
1977, Chintagunta & Vilcassim 1992, Dub & Manchanda 2005, Dub, Hitsch & Manchanda 2005). Other
work has examined the relationship between advertising and goodwill (Doganoglu and Klapper 2006) and
advertising and brand perceptions (Clark, Doraszelski & Draganska 2009). Our model builds on these
findings. We develop share-based estimates of brand equity and examine how they correlate with advertising
decisions. We structurally estimate a dynamic oligopoly model of advertising competition in the Ericson &
Pakes (1995) framework. This will allow us to avoid some of the limitations that have characterized many of
the previous approaches, as our model will (i) include advertising as an endogenous forward-looking decision
by firms; (ii) allow brands that interact strategically; and (iii) contain demand estimation that is rooted in
a model of consumer behavior.

2.4 Estimation and Calibration of Dynamic Oligopoly Models

The recent empirical literature on dynamic models of oligopolistic competition largely builds on Ericson &
Pakes (1995). This seminal paper provides a framework for estimation of models of dynamic competition
in an oligopolistic industry that includes investment, entry, and exit. (See Doraszelski & Pakes (2007)
for an extensive discussion of the framework and the related literature.) More recently, several papers

Section 3

have introduced methods for structural estimation of models in the Ericson & Pakes (1995) framework
(Aguirregabiria & Mira 2007, Bajari, Benkard & Levin 2007, Pakes, Ostrovsky & Berry 2007, Pesendorfer
& Schmidt-Dengler 2008, and Su & Judd 2008). This has led to a number of applications. For example,
the framework has been used to study the dynamic R&D investment and pricing strategies of durable good
oligopolists in the PC microprocessor industry (Goettler & Gordon 2009), and bidding behaviour in auctions
for sponsored search advertising (Yao & Mela 2010). An alternative approach to structural estimation of
the dynamic game involves calibration in the spirit of Benkard (2004). Dub, Hitsch & Rossi (2009) devise a
dynamic model of price competition that allows them to assess the effect of switching costs on the intensity
of price competition and calibrate the model using data from CPG categories. Dub, Hitsch & Chintagunta
(2010) devise a model of platform competition that incorporates indirect network effects and propose a
method for measuring the increase in market concentration that is attributable to the presence of indirect
network effects; they calibrate the model using data on the video game console industry. As explained above,
we contribute to this literature by devising and structurally estimating a dynamic oligopoly model of brand
building.

3 Category Description and Data

In this section, we describe the stacked chip category and the data that we use to estimate our model.

3.1 Category Description

The stacked chip category originated with Pringles at Procter & Gamble (P&G) during the late 1960s, after
over a decade of product development. P&Gs plan was to distribute Pringles over its existing distribution
network, which was optimized for non-perishable items. To ensure the chips didnt spoil while in transit, they
were to be packed in nitrogen, which necessitated a cheap airtight seal. This in turn lead to the now wellknown clindrical containers and the uniformly-shaped, stackable chips that would fit them. By the mid-1990s
more than $1 billion in annual sales. In 2012, P&G agreed to sell Pringles to Kelloggs for nearly $2.7 billion.3
Frito-Lay, a division of PepsiCo, launched Lays STAX in 2003. Like Pringles, STAX chips are packaged
in cylindrical containers and are are uniformly-shaped and stacked for improved packing efficiency. Our
data shows that STAX was able to capture a market share of 6 percent in the chips category and 20 percent
in the stacked chips category after only 3 years on the market.
3.

Kelloggs

buys

Procter

&

Gambles

Pringles

chips

for

$2.7

billion.

http://articles.latimes.com/2012/feb/15/business/la-fi-mo-kellogg-pringles-sale-20120215

Retrieved

April

11,

2012.

Category Description and Data

3.2 Data
We estimate the model using data on the salty snacks category from the IRI Marketing Data Set (Bronnenberg, Kruger & Mela 2008). The sales data describe each purchase of a product in numerous catergories,
including potato chips, that was made in participating stores in each of 47 U.S. markets between January 1,
2001 and December 31, 2006. This data set is well-suited for this project for multiple reasons. First, it is very
detailed; for each sale, the price, volume, region, product characteristics, and week of purchase are reported.
All of these data items are necessary for estimating brand equity using a method like the one proposed
in Goldfarb, Lu & Moorthy (2009). Second, within the time period covered by the data set, we observe
interesting dynamics due to the entry of STAX, and the resulting competition. The variance in market
share and advertising allow us to identify the dynamic parameters in our model. Third, the IRI Marketing
Data Set contains advertising spending for the catergory that was provided by TNS Custom Research,
which spans from January 1, 2001 until June 30, 2006. These comprehensive data sets make it possible to
apply our model to this industry, while the interesting dynamics and duopolistic industry structure make it
interesting to do so. We provisionally focus on the time period where both STAX and Pringles are active
in the market, which spans from the fourth quarter of 2003 to the second quarter of 2006. We deflate all
dollar amounts to year 2000 dollars using the Consumer Price Index.

3.3 Descriptives
Descriptive statistics for each brand are provided in tables 1 and 2 below. Plots of advertising spending, sales,
market share, and price are presented in figures A, B, C, and D, respectively. Figure A shows substantial
variability in ad spending by quarter for both brands. Figures B and C show that sales and market share
are more stable than advertising, though there is still substantial variation over time. Figure D shows that
STAX prices are slightly below Pringles, though the gap varies from almost zero in the second quarter of
2004 to close to 20 percent in the first quarter of 2006.
Pringles Descriptives
Advertising (Millions of Dollars)
Price (Dollars)
Market Share
Sales (Millions of Dollars)

Mean
9.66
1.18
0.21
4.89

Standard Deviation
4.33
0.05
0.01
0.38

Min
2.17
1.10
0.19
4.49

Table 1.

STAX Descriptives
Advertising (Millions)
Price (Dollars)
Market Share
Sales (Millions)

Mean
4.01
1.07
0.05
1.12

Standard Deviation
4.73
0.09
0.01
0.12

Table 2.

Min
0.00
0.96
0.04
0.93

Max
12.56
1.23
0.06
1.28

Max
17.62
1.26
0.23
5.42

Section 4

4 Static Price Competition

In this section, we present the static model of price competition and discuss our approach to estimating the
model. We also present the results of the estimation, which yields quarterly estimates of brand equity for
Pringles and STAX respectively and an estimate of the period profit function. These are treated as primitives
in the dynamic model that is presented in section 5.

4.1 The Static Model of Price Competition

We assume that firms engage in price competition in each period given the brand equities that prevail in
that period. Because the static model of price competition is parameterized by the industry state of the
dynamic modelwhich comprises firms respective brand equitieswe will first describe the state space of the
dynamic model.
Firms and states. Firm n {1, 2} is described by its state n {0, 1, , M }. States 1, , M describe the
brand equity of a firm that is active in the product market, i.e., an incumbent firm, while state 0 identifies a
firm as being inactive, i.e., a potential entrant. The vector of firms states is = (1, 2) {0, , M }2 and
we use [2] to denote the vector (2, 1) obtained by interchanging firms states.
Product market competition.

The product market is characterized by price competition between firms

with products that are vertically differentiated acording to their respective brand equities.

In order to

estimate the model, we incorporate week-specific stochastic shocks to accomodate the inevitable variability in
price and sales within states and across weeks. Accordingly, we incorporate week-specific shocks to market
size and to each firms marginal cost. There is a continuum of consumers. Each consumer purchases at
most one unit of one product in each week. The utility that consumer i derives from purchasing from firm n
is uin(n) = g(n) pn + n + + (1 )in, where g: (0, 1, , M ) R is an increasing function that maps
brand equity state n into the consumers valuation of it (which is its brand equity4), pn is the price, n is
a mean zero firm-specific shock, is a week-specific industry-wide shock, and in represents the consumerss
idiosyncratic preference for product n. We set g(0) = ; this ensure that potential entrants have zero
demand and thus do not compete in the product market. There is an outside alternative, product 0, which
has utility + (1 )0. Assuming that the idiosyncratic preferences 0, 1, and 2 have independent and
4. Formally, n is the brand equity state and g(n) is the brand equity. For ease of exposition, we sometimes refer to n
as brand equity as well.

Static Price Competition

identically distributed type 1 extreme value distributions, and that and have distributions depending on
such that + (1 )in and + (1 )i0 have extreme value distributions, the demand for incumbent
firm ns product is
Dn(p; , m, ) = m

exp (

g(n) pn + n
)
1

C +C

(1)

where p = (p1, p2) the vector of prices, is the price coefficient, m > 0 is the size of the market (the measure
of consumers), = (1, 2) is the vector of week-specific shocks to consumer utility for each brand, and
C = 2j =1exp(g(j ) p j + j ). The market size m is assumed to have an independent normal distribution
with mean m and standard deviation m. n is assumed to have a mean zero normal distribution with
standard deviation .
Incumbent firm n chooses the price pn of its product to maximize profits. Hence, its profits in state are
n(, cn , m, ) = max Dn((pn , pn); , m, )(pn cn),
pn

(2)

where pn is the price charged by the rival and cn 0 is the marginal cost of production for firm n. We
assume that the marginal cost is drawn from a normal distribution with mean c and standard deviation
c and is independently and identically distributed across weeks. Given an industry state , a vector of
marginal costs c, and a vector of weekly shocks , there exists a unique Nash equilibrium of the product
market game (Caplin & Nalebuff 1991). It is found easily by numerically solving the system of first-order
conditions corresponding to incumbent firms profit-maximization problems. Let n (, c, m, ) denote firm
ns equilibrium profit. Integrating over the market size, marginal costs, and the weekly shocks to brand
equity, we compute the expected equilibrium profit in industry state ,
n() =

n (, c, m, )f c(c)fm(m)f ()dcdm d ,

(3)

c,m,

where fc(c), fm(m), and f () are pdf functions of c, m, and , respectively. Because product market
competition does not directly affect state-to-state transitions, n() can be computed before the Markov
perfect equilibria of the dynamic stochastic game are computed. This allows us to treat n() as a primitive
in what follows.

4.2 Estimating the Static Model of Price Competition

We conduct two stages of estimationfirst estimating the static model of price competition and only then
estimating the dynamic model of brand building, which is presented in section 5for the following reasons.
First, in estimating a model in the Ericson & Pakes (1995) framework, one typically observes the states in

10

Section 4

the data. For example, in the Goettler & Gordon (2011) study on R&D competition between Intel and AMD,
the authors observe processor speed, which they regard as a proxy for product quality. In this study, we are
unable to observe brand equities, which serve as states in our model, and therefore must estimate them prior
to estimating the dynamic model. Our approach to estimating the static model of price competition yields
quarterly estimates of Pringles and STAX brand equities respectively. Second, the period profit function
in models in the Ericson & Pakes (1995) framework can be treated as a primitive because it does not affect
state-to-state transitions in the dynamic game. It follows that in estimating a model in the Ericson & Pakes
(1995) framework, one can estimate the period profit function before estimating the dynamic model. In the
first stage of estimation, we estimate the period profit function that results from the static model of price
competition. Having estimated brand equities and the period profit function, we are then able to proceed
to estimation of the dynamic game in the second stage.
We assume that firms engage in static price competition in each week given the brand equities that prevail
in that week. Moreover, we assume that brand equities are fixed within each quarter. We use the subscript t
to reference the value of a variable in week t and the subscript q to reference the value of a variable in quarter q.
Estimation of the Demand Function. In this stage, we estimate the parameters that appear in the
demand function. Specifically, we estimate the brand equities g(qn), the price sensitivity parameter , the
standard deviation of the shocks to brand utility , and the mean m and standard deviation m of the
distribution from which market size is drawn. We estimate these parameters using a variant of the method
proposed by Goldfarb, Lu & Moorthy (2009). In particular, we estimate a nested logit demand model that
describes product market competition using instrumental varibles to account for the endogeneity of price.
The two stacked potato chips brands, Pringles and STAX, are in the same nest, while the outside good is
in a seperate nest. This captures the notion that brands of stacked potato chips will compete more fiercely
with each other than with other types of salty snacks. The brand equity of each firm in each quarter is
defined as the additional utility a consumer receives from consuming a branded product, as opposed to an
unbranded alternative. Operationally this is represented as a brand-quarter fixed effect in the consumers
utility function. The methodology allows us to map market shares and prices into brand equities. Recall
that the demand for good n is
Dn(pt; , mt , t) = mt

exp (

g(n) pnt + nt
)
1

Ct + Ct

And demand for the outside good, which exists in a seperate nest, is
D0(pt; , mt , t) = mt

Ct
.
Ct + Ct

11

Static Price Competition

In the case of stacked potato chips, the outside good is defined as all non-stacked chips, pretzels, popcorn,
and cheese snacks. The market size in each week, mt , is the total number of units of chips, cheese snacks,
pretzels, and popcorn sold in that week. We do not observe mt directly, as we only observe the stores
covered by the IRI database, so we approximate it as follows. From the data, for each week, we compute the
average household spending on all chips, pretzels, popcorn, and cheese snacks. We multiply this by the total
number of households in the U.S. to get an approximation of total U.S. spending on the aforementioned salty
snack categories. Because market size is defined in units, not dollars, we then multiply this by the average
number of units per dollar spent on these salty snacks. We use the first and second sample moments of these
approximations to estimate t and t. We are implicitly assuming that the stores represented in the IRI
database are a representitive sample of all U.S. stores.
Taking the difference between the log market share of a firm and the outside good, we have:
log

Dn(pt; q , mt , t)
mt

log

D

0(pt; q , mt ,

mt

t )



Dn(pt; q , mt , t)
= g(qn) ptn + log m D (p ; , m , ) + tn.
t

Because estimation of the above expression through standard ordinary least squares would be biased due
to the endogeneity of price (it is possible that firms observe t before setting prices) and the inside share,
we use the price in the previous period and the average price of the outside good as instruments. Through
reduced form analysis we have found that there is a strong correlation between current prices and previous
period prices, and in our model the relationship between the current period and the previous period is
captured through brand equity, making this a valid instrument. Similarly, we find that the average price of
the outside good to be correlated with the market share of stacked chips, but in our model it is independent
of the brand-week specific shock to uility t. We estimate demand on a weekly basis, with brand equities
which change each quarter. The results are presented in table 4. Figure E plots the estimated values of brand
equity for Pringles and STAX by quarter.
Estimation of the Marginal Cost Parameters. We use the first-order condition that characterizes
equilibrium price in the static period game to compute cnt the marginal cost each firm faced each week, given
the estimates of the parameters in the demand function.
Given the estimates of g(qn) and , we can compute marginal costs in each period as
1


cnt = pnt 
1 stn 1 + Ct( 1)

(4)

Figure F shows the estimated marginal cost values for Pringles and STAX over time. Given the estimates of
the marginal costs in each period, we can estimate c and c using the first and second sample moments of ctn.

12

Section 4

Correlation between Brand Equity and Advertising. The table below shows the relationship between
estimated brand equity and advertising. In particular, the table shows the results of regressions of changes
in brand equity on advertising expenditures and a number of controls. In each specification, advertising and
brand equity are positively correlated. In columns 3 and 4, we do not find a significant brand-advertising
interaction. This allows us to use the same parameters to describe the returns to advertising for each firm.
Finally, regression 4 in table 3 shows that lagged brand equity has an important effect on the change in brand
equity. Firms with higher brand equities are more likely decline. This justifies our modeling assumption
that the probability of sucessful advertising is a decreasing function of the current brand equity state.

Model 1
(S.E.)
-0.105***
( 0.043)

Model 2
(S.E.)
-0.164***
( 0.06)

Model 3
(S.E.)
-0.189***
( 0.069)

Model 4
(S.E.)
0.175
( 0.159)

Advertising (Millions)

0.01*
(0.005)

0.014**
(0.006)

0.017**
(0.007)

0.013*
(0.007)

STAX

0.086
( 0.061)

0.133
( 0.088)

-0.143
( 0.137)

STAX Advertising
(Millions)

-0.01
( 0.013)

-0.004
( 0.012)

Lagged Brand Equity

-0.238***
(0.096)

(Intercept)

Standard errors in parentheses. p < .10,

p < .05,

p < .01

Table 3.

Brand Equity Discretization. Because the Ericson & Pakes (1995) framework that we use to devise the
dynamic model has a discrete state space, we use a discrete approximation of the estimated brand equities.
The mapping from a firms brand equity state n {0, 1, , M } to its discretized brand equity is
g(n) =

if n = 0
ln + b if n > 0

for constants l > b 0, and each estimated brand equity is assigned to the discrete brand equity to which it
is closest. Within this class of discretizations, we searched for b and l that would minimize l, the distance
between states, while ensuring that from period to period, a firms discretized brand equity would increase
by at most one unit and decrease by at most two units. We allow for decreases of two units in order to
accommodate several big decreases in brand equity, which can be seen in figure E. In section 5, we explain
how we allow for this in the dynamic model. Our search found that b = 0.07488 and l = 0.144 provide the

13

The Dynamic Model of Brand Building

best approximation, an we used the resulting discretization for the estimation of the dynamic model. We
observe a span of 14 states in the data, but use a span of 19 for each firm in our model to ensure that our
results are not being driven by the edge of the state space. This discretization is displayed in Figure E.
Estimation of Expected Profits. We cannot dervive the expected profit in equation (3) analytically
because there is no closed-form solution for n (, ct , mt , t). This is because equilibrium prices must be
computed using numerical methods. We therefore approximate the expected profit in each state through
monte carlo simulation. As explained above, estimating the static model of price competition allowed us to
estimate the parameters of the distributions from which c, m, and are drawn. From these distributions,
we drew 10,000 pairs of monte carlo samples, which we denote ci, mi, and i5.

Let p( |c, m, ) be the

vector of equilibrium prices in industry state given c, m, and . The monte carlo estimate of the expected
profit for firm n in industry state is
n()

10,000
X
i=1

Dn(pn( |ci , mi , i); , mi , i)(pn( |ci , mi , i) ci)

.
nsamples

We approximate the expected profit for each industry state {1, , 19} {0, 1, , 19}.
The plots of expected price, expected quantity demand, expected market share, and expected profit are
presented in Figure G. Both a firms market share and its profit increase relatively rapidly as its brand
equity increases. However, the gains to increases in brand equity are larger when competiting against a low
brand equity competitor.

5 The Dynamic Model of Brand Building

In this section, we present the dynamic model of brand building and discuss our estimation strategy. The
dynamic model is informed by the results of the estimation of the static model of price competition and
the descriptive empirical analysis of the relationship between our brand equity estimates and advertising
expenditures. In particular, because of the insights derived from these exercises, we make the following
assumptions in the dynamic model. First, we assume that from quarter to quarter, a firms brand equity
can increase by one unit and decrease by up to two units. This assumption is made to accommodate the
fact that while we see only relatively small increases in brand equity from period to period. we see a few
relatively big decrease in brand equity, as is seen in figure E. As explained above, this assumption allows
us to use a much finer discretization of the brand equity continuum than would be possible if we restricted
transitions to immediately adjacent brand equity states. Second, we assume that advertising stochastically
5. In the implementation, we analytically integrate over mt.

14

Section 5

enhances brand equity, which is in line with the positive correlation between advertising expenditures and
changes in brand equity that is discussed in section 4.2. Third, we assume that the expected effectiveness
of a firms advertising is decreasing in its brand equity. This is motivated by the finding that the higher a
firms brand equity, the more likely it is to decline, discussed in section 4.2. Fourth, because we do not find
a significant brand-advertising interaction in the descriptive empirical analysis discussed in section 4.2, we
assume that firms are symmetric and therefore differences between firms are fully captured by the differences
between their respective brand equities, which arise endogenously. Fifth, we assume that brand equity is
subject to industry-wide depreciation (which is reflective of an increase in the equity of the outside good)
as opposed to firm-specific depreciationbecause we find that when controlling for advertising spending,
changes in brand equity are correlated across firms in each period (cor = .74, p=.014).

5.1 The Dynamic Model

We study advertising and brand equity within the context of a dynamic stochastic game in the Ericson &
Pakes (1995) framework. Our model is a richer version of the quality ladder model explored in Pakes &
McGuire (1994) and Borkovsky, Doraszelski, & Kryukov (2011). To allow for entry and exit in a way that
guarantees the existence of an equilibrium, we follow Doraszelski & Satterthwaite (2010) and assume that
setup costs and scrap values are privately observed random variables.
Timing.

Each period is divided into two subperiods. In subperiod 1 the sequence of events is as follows.

1. Each incumbent firm draws a private, random effectiveness of advertising and decides how much to
invest in advertising.
2. The advertising investment decision of incumbent firms are carried out and their uncertain outcomes
are realized. A common industry industry-wide depreciation shock affecting all incumbents is realized.

As a result, the industry state transitions from to (n , n

) and all firms observe the new

industry state.
3. Incumbent firms compete in the product market.
In subperiod 2, entry and exit decisions are made as follows.
1. Each incumbent firm draws a private, random scrap value and decides on exit. Each potential entrant
draws a private, random setup cost and decides on entry.
2. Entry and exit decisions are implemented. As a result, the industry state transitions from to

) and all firms observe the new industry state.

(n, n

15

The Dynamic Model of Brand Building

In the dynamic model, periods correspond to quarters. However, firms engage in static product market
competition in each week. While brand equity is held constant across quarters, market size, marginal costs,
and consumers idiosyncratic preferences for the two brands and the outside goodall of which are introduced
beloware redrawn each week.6 For the sake of conciseness, we omit time subscripts.
We first describe the static model of product market competition and then turn to advertising, entry,
and exit dynamics.
Incumbent firms. Suppose first that firm n is an incumbent firm, i.e., n  0. The state of the incumbent
firm n at the end of subperiod 1 is determined by the stochastic outcomes of its advertising decision and an
industry-wide depreciation shock. In particular, its state evolves according to the law of motion
n = n + n ,

(5)

where n {0, 1} is a random variable governed by the incumbent firm ns advertising xn 0 and {0,
1, 2} is an industry wide depreciation shock. If n = 1, advertising was successful and the brand equity of
incumbent firm n increases by one level. The probability of success is

n x n
,
1 + n x n

where n > 0 is a measure of

the effectiveness of advertisement. The effectiveness of advertising is independent across all periods and firms.
We assume that n = en k, where n is a private drawn from a gamma distribution (h, (n)) with shape
parameter h and scale parameter (n), and k > 0. We make this assumption about ninstead of simply
assuming that n itself is drawn from a gamma distributionbecause it allows the model to accommodate
a larger variance in the advertising expenditure decisions that arise in equilibrium. Because n is bounded
below by zero, we include the k term in n = en k so as to ensure that the model admits small n values.
The probability density function of the gamma distribution is denoted by g(.|h, (n)). We assume that
(n) = exp (an3 + bn2 + cn + d),

(6)

b2

where c < 3a and a < 0; it follows that (.) is a stricly decreasing function and, accordingly, a firms expected
advertising effectiveness is strictly decreasing in its brand equity.
If  0, the industry is hit by a depreciation shock that reduces each firms brand equity by either one
or two units. The depreciation shock is modeled as two independent and identically distributed draws from
a Bernoulli distribution with success probability . It follows that the distribution of the industry-wide
depreciation shock is

(1 )2 if = 0,
() = 2(1 ) if = 1,

2
if = 2.

6. We assume that firms engage in product market competition in each week because estimating the static model of
product market competition at the weekly level allows us to separately identify the brand equities and the price coefficient in
the consumers utility function.

16

Section 5

In subperiod 2, an incumbent firm decides whether to remain active or to exit. We model exit as a
transition from state n  0 to n = 0. We assume that at the beginning of subperiod 2, each incumbent
firm draws a random scrap value from a log normal distribution with scale parameter and shape parameter
. Scrap values are independently and identically distributed across firms and periods. Incumbent firm n
learns its scrap value n prior to making its exit decision, but the scrap value or setup cost of its rival remains
unknown to it. If the scrap value is above a threshold n, then incumbent firm n exits the industry and
perishes; otherwise it remains in the industry. This decision rule can be represented either with the cutoff
scrap value n itself or with the probability n [0, 1] that incumbent firm n remains in the industry in state
R
because n = 1(n n)dF(n) = F (n) where 1() is the indicator function, is equivalent to n = F 1(n).

Potential entrants. Suppose next that firm n is a potential entrant, i.e., n = 0. In subperiod 2, a potential
entrant decides whether to enter the industry. We model entry as a transtion from state n = 0 to state
n  0. We assume that at the beginning of subperiod 2 each potential entrant draws a random setup cost

from a log normal distribution with scale parameter e and shape parameter e. Like scrap values, setup
costs are observed privately and are independently and identically distributed across firms and periods. If
e
the setup cost is below a threshold n, then potential entrant n enters the industry; otherwise it persists

as a potential entrant. This decision rule can be represented with the probability n [0, 1] that potential
entrant n enters in the industry. Upon entry, potential entrant n becomes incumbent firm n and its state is
the exogenously given initial brand equity e.
Value and policy functions. Define Vn(, n) to be the expected net present value of firm ns cash flows
if the industry is currently in state and it has drawn effectiveness of investment n. Incumbent firm ns
value function is Vn : {1, , M } {0, , M } [0, ) R, and its policy functions n : {1, , M } {0, ,
M } [0, 1] and xn : {1, , M } {0, , M } [0, ) specify the probability that it remains in the industry
in state and its advertising in state given that it draws an effectiveness of advertising n, respectively.
Potential entrant ns value function is Vn : {0} {0, , M } R, and its policy function n : {0} {0, ,
M } [0, 1] specifies the probability that it enters the industry in state .
Bellman equation and optimality conditions. Suppose first that firm n is an incumbent firm, i.e.,
n  0. We first present the problem that incumbent firm n faces in subperiod 1. The value function Vn : {1, ,
M } {0, , M } [0, ) R is implicitly defined by the Bellman equation
Vn(, n) = max xn + E[n( )|, xn , x n(, n), n] + E[Wn( )|, xn , xn(, n), n],
xn >0

(7)

where (0, 1) is the discount factor and

E[n( )|, xn , x n(, n), n] =

en kxn
en kxn
1
Y
()
+
Yn0()
n

k
1 + e n xn
1 + en kxn

(8)

17

The Dynamic Model of Brand Building

is the expected profit that incumbent firm n earns in subperiod 1 through product market competition.
Ynn() is incumbent firm ns expected profit conditional on an investment success (n = 1) or failure (n = 0),
respectively, as given by
Z
X
n
Yn () =
n

{0,1,2}
n {0,1}

en k xn(, n)
()
1 + en k xn(, n)

!n

1
n k
1+e
xn(, n)

!1n

n(max {min {n + n , M }, 1}, max {min {n + n , M }, 1})

g(n |h, ())dn.
The min and max operators merely enforce the bounds of the state space. The continuation value in the
Bellman equation (7) is
E[Wn( )|, xn , x n(, n), n] =

en kxn
en kxn
1
Z
()
+
Zn0 ().
n

k
1 + e n xn
1 + en kxn

(9)

Wn( ), which is defined formally below, denotes the expected net present value of all future cash flows to
incumbent firm n when it is in industry state at the beginning of subperiod 2. Znn() is the expected net
present value of all future cash flows to incumbent firm n when it is in industry state at the beginning of
subperiod 1 conditional on an investment success (n = 1) or failure (n = 0), respectively, as given by
!n
!1n
Z
X
en k xn(, n)
1
n
()
Zn () =
1 + en k xn(, n)
1 + en k xn(, n)
n
{0,1,2}
n {0,1}

Wn(max {min {n + n , M }, 1}, max {min {n + n , M }, 1})

g(n |h, (n))dn.
Solving the maximization problem that incumbent firm n faces in subperiod 1, which is on the righthand side of the Bellman equation (7), we obtain the complementary slackness condition for xn(, n):
1 +

xn(, n) 1 +

en k

Tn()
(1 + en kxn(, n))2

n k

6 0,

e
Tn() = 0,
(1 + en kxn(, n))2
xn(, n) > 0,

(10)

where Tn() Yn1() Yn0() + (Zn1 () Zn0 ()). Solving the complementary slackeness condition (10) for
incumbent firm ns optimal advertising spending, we find that
)
(
p
1 + en kTn()
xn(, n) = max 0,
en k

(11)

if Tn() > 0 and xn(, n) = 0 otherwise.

We now turn to the problem that incumbent firm n faces in subperiod 2. At the beginning of subperiod
2, the industry state is . The expected net present value of all future cash flows to incumbent firm n in
industry state is
Wn( ) =

max (1 n)E[n |n > F 1(n)] + nUnn( ).

n [0,1]

(12)

18

Section 5

Unn ( ) is the expected net present value of all future cash flows to incumbent firm n when it is in industry
state at the beginning of subperiod 2 and it transitions to state n during subperiod 2, as given by

= 0)Vn(n , e) + l(n
> 0)Vn(n , n
)},
Unn ( ) = (1 n( ))Vn(n , 0) + n( ){l(n

where
Vn() =

[ xn(, n) + E[n( )|, xn(, n), xn(, n), n]

(13)

+ E[Wn( )|, xn(, n), xn(, n), n]]g(n |h, (n)) dn.
Instead of the unconditional expectation E(n), an optimizing incumbent cares about the expectation of the
scrap value conditional on collecting it:

E {n |n F 1(n)} = e



+ 2 ln (F 1(n))


 .
ln (F 1(n))

Solving the maximization problem on the right-hand side of equation (12) and using the fact that (1
R
n)E[n |n F 1(n)] = F 1( ) ndF(n), we obtain the first-order condition for n():
n

F 1(n( )) + Unn( ) = 0.

(14)

The complementary slackness condition (10) and the first-order condition (14) are both necessary and
sufficient.
Suppose next that firm n is a potential entrant, i.e., n = 0. The value function Vn : {0} {0, , M } R
is implicitly defined by
Vn( ) =

max n {E {en |en 6 F e (n)} + Un ( )} + (1 n)Un0( )}.

1

n [0,1]

Instead of the unconditional expectation E(en), an optimizing potential entrant cares about the expectation
of the setup cost conditional on entering:

E {en |en F e1(n)} = e

Using the fact that n {en |en F e1(n)} =

for n(),

e2


 e e2
+ ln (F 1(n))

e
 e
 .
ln (F 1(n))

en F e 1(n)

endFe(en), we obtain the first-order condition

F 1(n( )) + {Un ( ) Un( )} =0,

which is both necessary and sufficient.

(15)

19

The Dynamic Model of Brand Building

Equilibrium. We restrict attention to symmetric Markov perfect equilibria in pure strategies. Existence is
guarenteed by an extension of the proof in Doraszelski & Satterthwaite (2010).7 In a symmetric equilibrium,
the advertising decision taken by firm 2 in state when it has drawn an effectiveness of advertising of
2 is identical to the advertising decision taken by firm 1 in state [2] when it has drawn an effectiveness
of advertising of 1, i.e., x2(, 2) = x1( [2], 2), and similarly for the value functions. Analogously, the
probability firm 2 is active in the next period in state is identical to the probability that firm 1 is active
in the next period given state [2] i.e. 2() = 1( [2]). It therefore suffices to determine the value and
policy functions of only one firm, to which we will refer as firm n. Solving for an equilibrium for a particular
parameterization of the model amounts to finding a value function Vn() and policy functions n() and xn()
that satisfy the Bellman equations and the optimality conditions for firm n.
This system comprises the incumbent firms Bellman equation
Vn(, n) = xn(, n) + E[n( )|, xn(, n), xn(, n), n] + E[Wn( )|, xn(, n), x n(,
n), n] ,
and optimal advertising equation (11) for {1, , M } {0, , M } and n (0, ); the incumbent firms
first-order condition (14) for {1, , M } {0, , M }; and the potential entrants Bellman equation
e

Vn() = n(){E {en |en 6 F e (n())} + Un ()} + (1 n())Un0()}

1

(16)

and first-order condition (15) for {0} {0, , M }.8

Becasue of the dependence of this system on n, it would be both challenging and computationally
burdensome to solve for solutions of this system. We therefore integrate out over n and instead solve for
an incumbent firms expected value and expected advertising spending. To this end, we define incumbent
firm ns expected advertising spending in industry state ,
Z
xn() =
xn(, n)g(n |h, (n))dn ,
n

and firm ns expected probability of successful advertising in industry state ,

Z
en kxn(, n)
g(n |h, (n))dn.
n() =
n kx (, )
n
n
n 1 + e
7. For any n (0, ), the transition function for subperiod 1 that is defined above is unique investment choice admissible
(Doraszelski & Satterhtwaite 2010). It follows that for any industry state , the mapping from firm ns advertising effectiveness
draw n to its optimal advertising spending, xn(, ), is a function. Moreover, this function is a unique best-reply to any
strategy played by firm ns rival. In subperiod 2, firms play cutoff entry/exit strategies, as in (Doraszelski & Satterhtwaite
2010). It follows that there exists a symmetric Markov perfect equilibrium in pure strategies.
8. We restate both the incumbent firms and the potential entrants Bellman equations because within the context of the
full system of equilibrium conditions, one removes the max function from each and replaces the choice variables xn and n with
the corresponding equilibrium policy functions, xn(, n) and n().

20

Section 5

Incumbent firm ns expected value in industry state , Vn(), has already been defined above in equation
(13). Because n is drawn from a gamma distribution, we can derive these analytically. In this case,

h
 


k
p
2
1
2(n)
xn() =
Tn() e 2
1 G log
+ k, h,
(17)
2 + (n)
Tn()
2 + (n)





1
(n)
ek
1 G log
+ k, h,

Tn()
1 + (n)
(1 + (n))
if Tn() > 0 and xn() = 0 otherwise, and
 


1
n() = 1 G log
+ k, h, (n)
T ()
  n 

1
2( )
h
1 G log T () + k, h, 2 + (n ) k
2
n
n
p
.
e2
2 + (n)
Tn()

(18)

We can now rewrite the system of equilibrium conditions, integrating out over n. Because we restrict
attention to symmetric equilibria, V1() = V2( [2]), x1() = x2( [2]), 1() = 2( [2]), and 1() = 2( [2]);
therefore, we can restrict attention to firm 1s problem. It follows that the vector of unknowns in equilibrium
is
=[V1(0, 0), V1(1, 0), , V1(M , 0), V1(0, 1), , V1(M , M ),
1(0, 0), , 1(M , M ), x1(1, 0), , x1(M , M ), 1(1, 0), , 1(M , M )].
The system comprises




V1() = xn1() + E 1( )|, 1(), 1([2]) + E W1( )|, 1(), 1( [2]) ,

(19)

and equations (17), (18) and (14) for {1, , M } {0, , M } and n = 1, and equations (16) and (15) for
{0} {0, , M } and n = 1. Therefore, equilibria are characterized by a system of 2(M + 1)(2M + 1)
equations in 2(M + 1)(2M + 1) unknowns. In this system, because we have integrated out over n, equations
(8) and (9) become
E[n( )|, n(), n()] = n()Yn1() + (1 n())Yn0(),
and
E[Wn( )|, n(), n()] = n()Zn1() + (1 n())Zn0(),
respectively.

5.2 Estimating the Dynamic Model

We estimate the dynamic model using maximum likelihood estimation. We maximize the likelihood of the
observed advertising spending decisions, entry/exit decisions, and state-to-state transitions. While we do
account for the entry/exit decisions in the likelihood function, we are not able to estimate the parameters of
the distributions from which setup costs and scrap values are drawn because we observe only one instance
of entry and no instances of exit. We therefore fix these parameters at values that seem reasonable. In

21

The Dynamic Model of Brand Building

particular, because we observe no instances of exit, we set the parameters of the log normal distribution from
which scrap values are drawn to values that will ensure that firms do not exit: = 20 and = 1. Because
there has been only one instance of entry since the stacked chips category was established 45 years ago, we
set ther parameters of the log normal distribution from which setup costs are drawn to values that yield
equilibrium entry probabilites of approximately 2% on an annual basis: e = 16 and e = 3. Finally, because
we cannot identify the discount factor , we set = 0.99, which corresponds to an annual interest rate of 4.1%.
We first explain how we derive the values of n that rationalize the observed advertising spending decions
and then explain how we construct the likelihood function and estimate the model using mathematical
programming with equilibrium constraints (MPEC) (Su & Judd 2012).
Rationalizing Advertising Expenditures. In the case that advertising spending is positive, we invert
equation (11) in order to derive the values of n that rationalize the observed advertising spending. Because
this inversion entails solving a quadratic equation, there are two values of n that rationalize every positive
advertising spending decision. Let n( q , xqn) (n1( q , xqn), n2(q , xqn)) be the vector of n draws that
rationalizes observed advertising spending xqn by firm n in industry state q . It follows that
(
"
#
p
T
(
)
+
T
(
)

4x
n
q
n
q
qn
n(q , xqn) = 2log
+ k,
2xqn
#
)
"
p
Tn( q) Tn( q) 4xqn
+k
2log
2xqn
if Tn(q ) 4xqn 0. To understand why two different n draws rationalize an observed advertising spending
decision, consider a firm that spends a relatively low amount on advertising. There is a relatively low draw
of nwhich implies a relatively low advertising effectivenessthat would justify this. In this case, becaue
the returns to advertising are low, it is not worthwhile for the firm to invest very much in advertising.
Alternatively, a relatively high draw of nwhich implies a relatively high advertising effectivenesswould
justify this too. When advertising is highly effective, even a small amount of spending nearly guarantees
success and, therefore, it is not worthwhile for the firm to spend more.
If Tn( q ) 4xqn < 0, then there is no draw of n that rationalizes observed advertising spending xqn by
firm n in industry state q . This is because given any equilibrium, there is an endogenous upper bound to
advertising spending for each firm in each industry state: xn()

Tn()
.
4

Intuitively, a firm never spends more

on advertising than the increase in the expected net present value of its future cash flows that would result if
its advertising were successful. Given an equilibrium, any advertising spending above this upper bound has


1
a likelihood of zero. Finally, it follows from equation (11) that given an equilibrium, if n < k + log T () ,
n

then xn() = 0. Therefore, the probability of observing zero advertising spending by firm n in industry state




1
is G k + log T () , h, (n) .
n

22

Section 5

MPEC. To estimate model, we use the MPEC approach proposed in Su and Judd (2012). In this approach,
we maximize the likelihood through a constrained optimization over both the parameters and the vector of
unknowns in equilibrium , using the the equilibrium conditions as the set of constraints.
We use this approach for two reasons.

First, we have found that thers is a significant increase in

computation speed relative to to tradtional nested fixed point estimation (Rust 1987).

Second, in our

particular problem, there are large areas of the parameter space where the log likelihood is undefined. This
occurs when observed advertising spending exceeds the endogenous upper bound on advertising spending
implied by an equilibrium. The MPEC approach allows us to add additional constraints to ensure that the
algorithm avoids these areas of the parameter space.

Let qn = (qn1
, qn2
) be the vector of possible advertising effectiveness as calculated by equation (19).

To estimate the model, we solve for the joint log likelihood of firms entry/exit decisions, firms advertising
spending decisions, and state-to-state transitions:
Y
X
max
log
[fn(xqn|q )l(xqn > 0)
{a,b,c,d,h,,}

n


+G k + log T

1
n( q)



, h, (qn) l(xqn = 0)]

+log (P (q|q , x q1, x q2))

!

Y
1l(
l( q +1,n =0)
q +1,n =0)
n(q )
(1 n(q))
+log
n

where l() is the indicator function, fn(xqn|q ) is the probability density function of firm ns advertising
spending in state q for xqn > 0 , which is given by
!
!
p
p
Tn( q ) Tn( q ) 4xqn
fn(xqn| q) = g 2log
+ k, h, (qn)
2xqn
p
p
2xqn
Tn(q ) 4xqn + p
Tn(q )
Tn( q) 4xqn
p
p
2


Tn(q ) Tn(q ) 4xqn xqn
!
!
p
p
Tn(q ) + Tn(q ) 4xqn
+ k, h, ( qn)
+ g 2log
2xqn
p
p
2xqn
Tn(q ) 4xqn + p
+ Tn(q )
Tn( q) 4xqn
p
p
,
2


Tn(q ) + Tn(q ) 4xqn xqn

and P (q|q , x q1, x q2) is the probability of the transition observed in the first subperiod of quarter q, from

state q at the beginning of the subperiod to state q at the end of the subperiod:
X

P (q |q, x q1, x q2) =

1
1 ( q ,x q1) 2 2 ( q ,xq2) 1 {0,1} 2 {0,1} {0,1,2}

l(q = (q + (1, 2) (1, 1))

r( q1, x q1)1(1 r( q2, x q1))11
r( q1, x q2)2(1 r( q2, x q2))12

g(2|h, ( q2))
g(1|h, ( q1))
P
()
g( |h, (q2))
g( |h, ( q1))

(q,xq2)

1 (q ,xq1)

23

The Dynamic Model of Brand Building

if q {1, , M } {1, , M },
X

P (q |q, x q1, x q2) =

1
1 (q ,xq1) 1 {0,1} {0,1,2}

l(q1
= q1 + 1 )
r( q1, x q1)1(1 r( q2, x q1))11

if q {1, , M } {0}

g(1|h, ( q1))
()
g( |h, (q1))
(q,xq1)
1

P (q |q, x q1, x q2) =

2
2 ( q ,xq2) 2 {0,1} {0,1,2}

l(q2 = q2 + 2 )
r( q1, x q2)2(1 r( q2, x q2))12

if q {0} {1, , M }, and

g(2|h, ( q2))
()
g( |h, (q2))

2 (q ,xq2)

P ( q | q , x q1, x q2) = 1
if q = q = (0, 0), where
r(, x) =

ekx
1 + ekx

is the probability that a firms advertising is successful when it receives a draw of and spends x on
advertising.9
We maximize the log-likelihood function subject to the system of equilibrium conditions described at the
end of section 5.1. To these equilibrium conditions, we add the aforementioned endogenous upper bounds
on advertising spending,
xqn 6

Tn(q )
4

for each xqn observed in the data, for the industry state q in which it is observed. Because these upper
bounds are endogenous, adding them to the system of constraints does not change the equilibrium set.
However, it does prevent the algorithm that we employ from searching for a solution in an infeasible region.
We have found that the algorithm suffers from convergence problems if these constraints are not included.
We coded the maximum likelihood estimation in GAMS and run the optimization using the KNITRO solver.
9. Note that the realization of the depreciation shock and the outcome of advertising spending may not be uniquely
identified in each period. For example, if both firms experience a one unit decrease in brand equity, this coudl be caused by
(i) a depreciation shock of one unit and unsuccessful advertising for both firms, or (ii) a depreciation shock of two units and
successful advertising for both firms.

24

Section 6

6 Results
Our estimation yields parameter estimates of = 0.3342, a = 4.73 105, b = 8.98 104, c = 0.0473,
d = 1.5639, h = 4.049, and an equilibrium of the model that is presented in Figure H. The parameters that
are not estimable are held fixed at the following values: = 0.99, k = 10, = 20 , = 1, e = 16 , and e = 3.

6.1 Measuring the Brand Value of Pringles and STAX

We are now able to devise a measure of brand value that accounts for the effect of a brands brand equity on
both current and future profits. To assess the value of a firms brand in a given industry state, we compare
the value of the brand in that industry state to its value in a counterfactual scenario in which it is endowed
with the lowest possible brand equity, while holding its rivals brand equity fixed. That is, the value of firm
ns brand when it possesses brand equity n in industry state = (n , n) is10
n() Vn() Vn(1, n).
This measure takes into consideration that if brand n were stripped of its brand equity, this would affect
both firms advertising spending decisions in the present and the future. Accordingly, this would affect the
market structure that would arise in the short-run and, potentially, in the long-run. These brand values
can be computed directly from the equilibrium value function presented in Figure H. That is, as exploring
the counterfactual scenario of interest involves changing the industry state but not the parameterization
of the model, one need not compute another equilibrium in order to measure the value of a firms brand.
We find that in the stacked chips category, brand equity has the potential to increase a brands value by
$1.29 billion. We find that a brand is most valuable when it possesses the highest possible brand equity
and it is a monopolist, i.e., in industry state (19, 0). We find that the entry of STAX causes the value of
the Pringles brand to decrease by $118.04 million, from (11, 0) = $614.13 million in the third quarter of
2003 to (10, 4)=$496.09 million in the second quarter of 2006. The value of the STAX brand decreased by
$96.99 million, from (6, 10)=$196.33 million in the fourth quarter of 2003in which STAX enteredto
(4, 10)=$99.34 billion in the second quarter of 2006. This suggests that competition from STAX reduced
the value of Pringles brand and, moreover, that the increased competitiveness of the category resulted in a
reduction in value of both firms brands.
10. Because firms are symmetric, the value of firm 1s brand in state is equal to the value firm 2s brand in state [2],


i.e., 1() = 2 [2] . Hereafter, we drop the firm subscript and report brand values from the perspective of firm 1.

25

Counterfactual Experiments

6.2 The Drivers of Brand Value

The equilibrium advertising spending policy function is presented in Figure H. A firms advertising behaviour
is characterized by two properties. First, a firms investment in advertising is increasing in its own brand
equity up to a brand equity level of 14 and declining thereafter. The figure in the bottom-right panel of
Figure H presents the mean of the distribution from which n is drawn; it shows that the effectiveness
of a firms advertising decreases quite rapidly as its brand equity increases. For brand equity levels above
14, advertising is sufficiently ineffective to induce a decline in advertising spending, despite the fact that a
firms period profits increase quite rapidly in its brand equity. Second, a firms investment in advertising is
declining in its rivals brand equity. We are also able to comment on the probability of successful advertising,
which is presented in the bottom-left panel of Figure H. For sufficiently low levels of brand equity, a
firms advertising is successful approximately 80% of the time. However, this probability that advertising
is successful declines rapidly as a firm brand equity increaseseven in the face of increasing equilibrium
advertising spendingbecause its advertising becomes less effective.
To explore the implications of the equilibrium behavior for the dynamics of the industry, both in the
short-run and in the long-run, we compute the transient distribution over states in period t starting from the
state observed in the final period of our data set (the fourth quarter of 2006), = (10, 4). Figure J displays
the transient distributions in periods 8, 24, and 256. From the transient distributions in periods 8 and 24,
we see that while Pringles is likely to retain its brand equity advantage in the short-term, STAX is likely to
narrow it. By period 256, the transient distributions have converged and, therefore, the transient distribution
for this period can be regarded as being reflective of the long-run industry structure. It shows that the
industry evolves toward a symmetric industry structure with a modal state of = (9, 9). That is, if firms
play the equilibrium advertising strategies presented in Figure H, then STAX is likely to eventually catch up
to Pringles. This occurs for multiple reasons. First, STAX never gives upi.e., it never stops advertising
no matter how far it falls behind Pringles. Second, even though Pringles invests more in advertising than
STAX when it is in the lead, STAX benefits from a higher advertising effectiveness. Therefore, STAX is
more likely to advertising successfully despite its lower advertising spending.

7 Counterfactual Experiments
In this section, we explore several counterfactual scenarios of interest.

For each, we examine how the

counterfactual scenario impacts brand building incentives, the evolution of brand equities, and accordingly
brand values. In subsection 7.1, we explore the effects of various changes in industry fundamentals. In section
7.2, we explore scenarios in which a brand with high brand equity can exploit opportunities to leverage its

26

Section 7

brand equity that are not available to low equity brands. In section 7.3, we explore the effects of reducing
the uncertainty that firms face about the effectiveness of advertising.

7.1 The Effect of Industry Fundamentals on Brand Value

We explore the effects of changes in industry fundamentalsin particular, the effectiveness of advertising,
the rate of depreciaiton of brand equity, and the market sizeon brand building incentives, the evolution
of brand equity over time, and accordingly brand value. We use the industry state observed in the final
period of our data set (the fourth quarter of 2006), = (10, 4), as a benchmark. The first row of Table 4
reports the brand values of Pringles and STAX, respectively, in industry state (10,4). It also reports the
modal states of transient distributionscomputed using industry state (10,4) as the starting pointfor
periods t = 8, t = 24, and t = 256, which are reflective of the evolution of industry structure over time.11 The
additional rows of Table 4 present the changes in the the brand valuesrelative to those that correspond to
the estimated parameterizationand the modal states of the transient distributions for the counterfactual
scenarios. To explore the effects of changes in the depreciation rate, , and the market size, m, we increase
and decrease the estimated parameter values by 20%. To explore the effects of changes in the effectiveness
of investment, n = en k, we increase and decrease the value of nfor any possible draw of nby 20%
by changing k from its benchmark value of k = 10 to k = 10 ln (1.2) and k = 10 ln (0.8), respectively.
parameter value

Pringles
496.1

k = 9.818
k = 10.223
= 0.40104
= 0.26736
M = 786, 377, 772
M = 524, 251, 848

+3.0%
-3.5%
-19.2%
+10.0%
+23.6%
-22.8%

Estimated equilibrium
Ad effectiveness: +20%
Ad effectiveness: -20%
Depreciation rate: +20%
Depreciation rate: -20%
Market size: +20%
Market size: -20%

STAX t = 8 t = 24 t = 256
99.3
(10,5) (9,7)
(9,9)
+4.4%
-5.3%
-39.0%
+26.0%
+25.3%
-24.2%

(10,5) (10,8)
(9,9)
(10,5) (9,7)
(8,8)
(9,4)
(1,1)
(1,1)
(11,7) (11,10) (11,11)
(10,5) (10,8)
(9,9)
(10,5) (9,7)
(8,8)

Table 4. Brand values and modal states of transient distributions for the estimated equilibrium and counterfactual
scenarios.

Table 4 shows that an increase (decrease) in the effectiveness of advertising increases (decreases) the
brand values of both brands by somewhat similar magnitudes. An increase (decrease) in the effectiveness
of advertising induces both firms to increase (decrease) ad spending. Accordingly, the expected brand
equities of both brands are slightly higher (lower) in all periods, relative to the baseline scenario.12 While
11. The industry structure for t = 256 can be regarded as the long-run industry structure becaue by this period, the transient
distributions have converged.

Conclusion

27

of greater magnitude, the results for the market size counterfactuals are qualitatively similar. However, we
find that changes in the rate of depreciation have a much larger effect on the brand values of STAX than
those of Pringles. When the rate of depreciation is decreased by 20%, the brand values of both brands
increase significantly because the brand equities that arise in the long-run are higher than those in the
baseline scenario. However, the brand value of STAX increases much more than that of Pringles because
the the industry structure becomes more symmetric in the short-run, as is demonstrated by the modal
states presented in Table 4. When the rate of depreciation is increased by 20%, Table 4 shows that in the
long run, neither firm will be able to sustain any brand equity. However, because Pringles has much more
brand equity in industry state (10,4) than STAX does, it takes longer for all of Pringles brand equity to be
depleted. Accordingly, Pringles earns much higher cash flows as the industry transitions from industry state
(10,4) to (1,1).

7.2 Leveraging High Brand Equity

[TO BE ADDED.]

7.3 Reducing the Uncertainty about the Effectiveness of Advertising

[TO BE ADDED.]

8 Conclusion
Building on the Pakes & McGuire (1994) quality ladder model, we have developed an estimable model
of brand building and harvesting. We have estimated this model using data from the U.S. stacked chips
category. Our estimation has allowed us to measure the value of the Pringles and STAX brands. Moreover,
it has allowed us to explore the ways in which these brands build brand equity through advertising and,
accordingly, how their respective brand equities evolve over time.
As with any empirical paper, our approach has a number of limitations that can be seen as suggestions for
future research. First, because we chose to examine a duopoly, the computational feasibility of our model to
settings with three or more firms still needs to be explored. Second, both P&G and PepsiCo are multiproduct
firms that may not be directly maximizing brand-specific profit in their advertising and pricing decisions in
the stacked chips category. Third, we treat the competition between the brands as occuring at a national
level, while there are likely to be location-specific differences in preferences and ad effectiveness. And finally,
12. Because the change in expected brand equity is small, this is discerbale in some but not all of the modal states presented
for the ad effectiveness counterfactuals in Table 4.

28

Section 8

in order to estimate a computationally feasible and economically informative model, we made a number
of other simplifying assumptions on the timing of decisions, the nature of competition, the homogeneity
of consumer preferences, the availability of distribution channels etc. In different empirical contexts with
different data, these assumptions could be altered to create a richer model.
Notwithstanding these limitations, we believe our model and estimates help improve our understanding
of the process through which firms build and harvest their brands.

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33

Table 4. Demand Model Results

Quarter
Q1-2000
Q2-2000
Q3-2000
Q4-2000
Q1-2001
Q2-2001
Q3-2001
Q4-2001
Q1-2002
Q2-2002
Q3-2002
Q4-2002

Price
Coefficient
Sigma

Pringles Brand
Equity
2.0025***
(0.406)
1.7846***
(0.3803)
1.7943***
(0.3621)
1.6171***
(0.3646)
1.6522***
(0.367)
1.6202***
(0.3683)
1.8024***
(0.3748)
1.3743***
(0.3631)
1.2598***
(0.3399)
1.0856**
(0.3569)
1.2585***
(0.3417)
1.2004***
(0.3363)

STAX Brand
Equity
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
NA
0.5917
(0.4671)

Quarter
Q1-2003
Q2-2003
Q3-2003
Q4-2003
Q1-2004
Q2-2004
Q3-2004
Q4-2004
Q1-2005
Q2-2005
Q3-2005
Q4-2005

-2.2967***
(0.2665)
0.6067***
(0.1674)

Standard errors in parentheses. *p <.05, **p <.01, ***p <.001

Pringles Brand
Equity
1.3267***
(0.3454)
1.1714***
(0.3321)
1.3306***
(0.3281)
1.1814***
(0.3295)
1.2092***
(0.3283)
1.134***
(0.3049)
1.1968***
(0.315)
1.0397**
(0.3146)
1.1756***
(0.3142)
1.1229***
(0.3147)
1.1488***
(0.3211)
0.8181**
(0.2955)

STAX Brand
Equity
0.5766
(0.4481)
0.4685
(0.4626)
0.5535
(0.4491)
0.2969
(0.4056)
0.3404
(0.3908)
0.4106
(0.4122)
0.3669
(0.4062)
0.179
(0.4182)
0.2478
(0.3914)
0.2527
(0.3897)
0.2375
(0.3844)
0.0259
(0.3925)

34

6
5
4
3
2
0

2002Q1

2003Q1

2004Q1

2005Q1

2006Q1

2001Q1

2002Q1

2003Q1

2004Q1

2005Q1

Quarter
Figure A: Brand Advertising by Quarter

Quarter
Figure B: Brand Sales by Quarter

Market Share Over Time

Price per Unit Over Time

2006Q1

1.0
0.5
0.0

0.00

0.05

0.10

0.15

Price per Unit (Dollars)

0.20

1.5

2001Q1

Market Share

Sales (Millions of Dollars)

PRINGLES
STAX

10

15

Sales (Millions of Dollars) Over Time

Advertising (Millions of Dollars)

Advertising (Millions of Dollars) by Quarter

2001Q1

2002Q1

2003Q1

2004Q1

2005Q1

Quarter
Figure C: Brand Market Share by Quarter

2006Q1

2001Q1

2002Q1

2003Q1

2004Q1

2005Q1

Quarter
Figure D: Brand Price by Quarter

2006Q1

35

1.5
1.0
0.0

0.5

Brand Equity

2.0

2.5

Brand Equity by Quarter

PRINGLES
STAX
2001Q1

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

2005Q3

2006Q2

Quarter
Figure E: Brand Equity and Discretization by Quarter

1.0
0.8
0.6
0.4
0.2
0.0

Marginal Cost (Dollars)

1.2

Marginal Costs Over Time

PRINGLES
STAX
2001Q1

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

Quarter
Figure F: Brand Marginal Costs by Quarter

2005Q3

2006Q2

Expected Quantity Demanded (Millions)

Expected Price (Dollars)

Figure G: Period Game Nash Equilibrium

(Functions presented are for firm 1.)

1.5

0.5

0
15

100
50
0
15

10

5
0 0

15

10

10

Expected Profit (Millions)

Expected Market Share

150

15

10

36

0.3
0.2
0.1
0
15

5
0 0

100
80
60
40
20
0
15

15

10

10

5
2

5
0 0

15

10

10

5
2

5
0 0

37

Figure H: Equilibrium Plots

(Functions presented are for firm 1.)
Expected Advertising Cost (Millions)

Entry/Nonexit prob.

1
0.8

1()

x1()

0.6
0.4

2
0.2
0

15

15
15

10
5
2

10

5
0

15

10

10

5
0

Ad Sucess Prob.
20
18
0.8

16
14
h(1)

1()

0.6
0.4

12

0.2

10

8
6

15
15

10

10

5
2

5
0

10

15

20

38

Figure I: Transient Distributions over States given Initial State (10,4)

Transient Distribution over States in Period 8

Transient Distribution over States in Period 24

0.06
0.04
0.05
0.03
P()

P()

0.04
0.03

0.02

0.02
0.01

0.01

15

15
15

10

10

5
2

Transient Distribution over States in Period 256

0.04

P()

0.03
0.02
0.01
0
15
15

10

10

5
2

5
0

10

5
0

15

10
5
0