Advertisements as a Revenue Source

Q: I was talking to a friend the other day, and he said he had this brilliant idea. He thinks that if he started a business giving away free meals, he could make enough money, through advertisers that would want to place their ads on the boxes and containers that the food came in. He believed this money from advertisers such as Coca Cola or Nokia or whatever, could pay for operating costs, startup costs and eventually he would be making enough revenue that he would turn a profit. He also assumes some huge investor is going to fund the initial start up costs. Is there anyway you could help me with this, I know it wouldn't work, but I am having trouble figuring out how to back up why?

A: Thanks for the question! I must say, it's one of the most unusual questions to appear in my inbox.

There are a few industries which do survive entirely on advertising revenue, just as your friend suggests. Radio and pre-cable television are two prime examples. Radio stations provide a service to the listener for free. They can make a profit because advertisers are willing to pay the station in order to broadcast their message to the listeners of that station. The radio station can turn a profit because the advertising revenue that they bring in more than outweighs the costs they face.

Radio and television stations have to survive in this manner due to the problem of excludability. As a radio station, I can't decide who I will allow to listen to the station and who will not be allowed to. This is important, because if I can't exclude people from using my product then it is very difficult to charge for it. If I'm selling oranges, I can say, "If you want an orange, you must pay me 50 cents". An owner of a radio station cannot do this as he has no way of controlling who gets his product.

Excludability is important as it causes an industry to have an unusual cost structure. The marginal cost of another listener to a radio station is zero. The costs the radio station faces in having 100,000 listeners or 100,001 listeners are exactly the same. Although the lack of excludability is a problem for companies as they cannot charge people directly for a service it is a benefit to them because their costs do not rise as their audience increases.

The problem with your friend's idea is the fact that marginal costs in an excludable industry are greater than zero. Let's suppose each of these meals costs us $4 to make and distribute. Assuming these meals were desirable, we should see an incredibly high level of demand for them. This leads to two possible scenarios:

1. Most (if not all) days we do not have enough meals for everyone. Many people will go away empty handed. This will prevent people from coming in the future, and the people who will be driven away are those who are least in need of a free meal.
2. We can satisfy people most days I think there will still be a problem here as even if we can give a meal to everyone who shows up, it takes time to distribute meals to everyone in line. It's likely that the long lines will cause the people who are least in need of a free meal to leave.

In both scenarios, the people who end up getting the meals (and therefore see the advertising) are the people who are the most willing to spend time to get a $4 meal. While from a philanthropic viewpoint this is good, from an adverising standpoint this is a disaster. People who have the time to wait for a $4 meal probably do not have much disposable income and thus are those who are least attractive to advertisers.

While there is no economic law that states this can never work, it seems unlikely that advertisers will be willing to pay $4+ to reach these people when there are so many other forms of advertising.

If you'd like to ask a question about advertising economics or any other topic or comment on this story, please use the feedback form.