This study attempts to answer a simple question: how important are economies of scale in advertising agency operations? Advertising agencies, like most other businesses, are multiple-product firms. An agency's costs may depend on how their clients allocate their advertising budgets across media and there is considerable variation in media mix among agencies. (SectionII provides some quantitative information on this variation.) Accordingly, we use nonlinear estimation techniques to examine the influences of both scale and media mix on advertising agency costs.
We find evidence that scale economies may not be as important as many have argued and that media mix is. a significant determinant of costs. Differences in media mix between large and small agencies seem typically to lower the costs of the former relative to the latter even if all economies of scale have been exhausted.
The question of scale economies underlies a number of current and long standing controversies related to advertising agency operations. First, the ability to exploit economies of scale is often given as a rationale for agency mergers. However, much skepticism has also been expressed about the realization of such an advantage through mergers and acquisitions (Kanner 1979) and the Federal Trade Commission reportedly did not view several mergers involving large agencies as serious threats to competition (Gordon 1979). Secondly, the issue of economies of scale underlies the problem of designing an equitable agency compensation scheme (Calantone and Drury 1979, Gross 1972). Both agencies and clients have voiced dissatsifaction with the traditional agency compensation arrangement, wherein the agency's fee is a fixed percentage, typically 15 percent, of the client's gross spending on advertising media (Booz, Allen & Hamilton 1965, Frey and Davis 1958).
This dissatisfaction is usually based on the perception of economies of scale at least with respect to account size: agencies complain that they are underpaid by small accounts, and clients are suspicious of being overcharged for large campaigns. Still, the most recent study bearing on this issue conducted by the Association of National Advertisers (1979) found that the commission system continues to be the dominant method of compensation with 57 percent of the 236 advertisers surveyed reporting they utilized media commissions plus markups-on production costs,' while. another 18 percent employed a combination of commissions and fees. Finally, evidence on scale economies might contribute to a satisfactory explanation of the limited incidence of "in-house" as opposed to "independent" agencies.
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