(FORTUNE Magazine) – Philadelphia retailing legend John Wanamaker spoke for many business people when he complained in 1885 that "half the money I spend on advertising is wasted, and the trouble is I don't know which half." The economists of his day couldn't have helped him. No one back then had thought very rigorously about what advertising was or why or how it worked. Few economists did anything to unravel its mysteries for the next 75 years. Only in recent decades have they begun to study advertising as an important commercial phenomenon. While economics still can't provide specific advice on what kind of ads you should run, it is producing insights that can help you think about how advertising affects the markets you deal in and your company's performance. Recent research on advertising helps explain, for instance, the success of certain companies -- including the discount chains that have overpowered the department stores Wanamaker helped create. When economists began studying advertising in the Sixties, they had little trouble understanding the kind of ads that provide hard information on things like prices, locations, and hours of operation. Such advertising helps companies disseminate information and gives consumers a better sense of the number of sellers, range of goods, and available prices. It's exactly the kind of rational behavior that can be explained by the laws of supply and demand and measured and tested with traditional tools of economic analysis.

BUT WHAT about advertising that doesn't convey any information as hard-edged as, say, a price? Turn on your television or open the newspaper and you're bombarded by vague claims and amorphous promises that only the most gullible consumer would take at face value. What, exactly, does "value you can count on" tell you? Economists in the Seventies began studying how such advertising might in fact be providing information -- specifically, by giving signals about product quality. A key conclusion was that a company could signal that it was big and profitable by advertising on a large scale -- implying that it must be offering a good product and satisfying customers or it wouldn't be able to afford the ads. In a series of recent research papers* Kyle Bagwell of Northwestern University and Garey Ramey of the University of California at San Diego build on and extend this work to look at advertising in the retailing industry. By advertising heavily, even if vaguely, Bagwell and Ramey argue, retailers attract more shoppers to their stores through they-must-be-doing-some thing- right logic. The increased traffic enables a retailer to offer a wider selection of goods, raises his incentive to invest in cost-reduction technologies such as computerized inventory, satellite communications, and modern warehouses, and lets the retailer exploit manufacturers' quantity discounts, further lowering marginal costs. This theory of "complementarities," as economists say, helps explain the success of retail juggernauts that understood it, like Wal-Mart and such category killers as Circuit City, Home Depot, and IKEA, which offer low prices and tremendous variety within a narrow product range. Most big, old retailers, by contrast, didn't make the most of the complementarities.

USING TECHNIQUES from game theory and microeconomics, Bagwell and Ramey have built a model (or set of equations) to study formally the relationships between retailers and consumers. The model confirms that advertising can promote efficiency even if it provides no hard information, by signaling to consumers where the big-company, low-price, high-variety stores are. It also shows that the ability to advertise leads to a more concentrated market structure -- fewer, bigger firms. And it demonstates in a new way what advertisers have long contended, that advertising is a net plus for society, in that it tends to lower prices and increase variety. The research also provides an explanation for an empirical puzzle. An earlier economist had asked why, in the retail eyeglass industry, prices were lower, market structure was more concentrated, and large-scale, low-price outlets were more common in markets that permitted advertising but prohibited advertisers from mentioning price information. Now we know. The next time you come across an ad slogan saying something like "We're better because we're bigger and we're bigger because we're better," consider that while it may be some copywriter's babble, it may also be a rather profound observation on the nature and development of the business enterprise. As for old John Wanamaker -- he probably wasted less on advertising than he thought.

FOOTNOTE: *American Economic Review, June 1994; Journal of Economics & Management Strategy, Summer 1993; Review of Economic Studies, January 1994.