Final answer:
Firms using competitive parity set their communications budgets by matching their closest competitors' spending to prevent losing market share and aim to reach equilibrium in brand recognition and customer capture.
Step-by-step explanation:
The spending strategy where firms set their communications budgets by observing the spending of their closest competitors is known as competitive parity. In markets such as those dominated by Coca-Cola or Pepsi, significant advertising and marketing are required to create a recognizable brand name. In settings where businesses act as monopolistic competitors or oligopolies, there might be a tendency towards collusion, where firms work together to control output and maintain high prices, or they competitively differentiate to capture market share.
Competitive parity is used as a defensive strategy to prevent losing out to competitors based on communication spend. However, this approach does not guarantee effective marketing and can lead to a neutralization effect where the efforts of one firm are offset by the efforts of another, leaving the market position unchanged. Firms may leapfrog one another to capture the maximum number of customers, eventually leading to an equilibrium where market shares are roughly even and each firm tries to distinguish themselves through other means such as price, service, and product differentiation.