The table shows the relationship for a hypothetical firm between its advertising expenditures and the quantity of its out-put that it expects it can sell at a fixed price of $5 per unit.
Advertising Quantity Sold at P = $5/IN
Expenditures (millions) Million Units
$1 8
$1.2 9
$1.4 9.4
$1.6 9.6
$1.8 9.7
a. In economic terms, why might the relationship between advertising and sales look the way it does?
b. Assume that the marginal costs of producing this product (not including the advertising costs) are a constant $4. How much advertising should this firm be doing? What economic principle are you using to make this decision?
take a shot, what do you think?
Hint: calculate the change in revenue from each 0.2 increase in advertising, subtract the marginal cost of producing that extra unit. (e.g., calculate the change in profit from each 0.2 increase in advertising). Keep increasing advertising until this term goes to zero or negative.
1.8 million where MR = 2.5 mil?
a. The relationship between advertising and sales may look the way it does due to the law of diminishing returns. Initially, as the firm increases its advertising expenditures, the quantity of output it expects to sell also increases. This is because the firm is reaching new customers and increasing brand awareness. However, as the advertising expenditures continue to increase, there comes a point where the additional increase in sales diminishes, and the firm reaches a saturation point. This means that beyond a certain advertising expenditure level, the impact on sales becomes less significant. This is why the quantity sold increases at a decreasing rate for higher advertising expenditures in the table.
b. To determine how much advertising the firm should be doing, we need to consider the principle of marginal analysis. Marginal analysis involves comparing the additional benefit (in this case, the increase in sales) with the additional cost (advertising expenditures).
In the table provided, we can calculate the additional benefit by looking at the change in quantity sold for each increase in advertising expenditure. For example, when the advertising expenditure increases from $1 to $1.2 million, the quantity sold increases from 8 million units to 9 million units. Therefore, the additional benefit is 1 million unit.
The additional cost is the difference in advertising expenditure between two data points. For example, when the advertising expenditure increases from $1 to $1.2 million, the additional cost is $0.2 million.
To make the decision on how much advertising the firm should be doing, we compare the additional benefit with the additional cost. Assuming that the marginal costs of producing the product (excluding advertising costs) are constant at $4, we want to find the point where the additional benefit equals the marginal cost. In this case, 1 million units is the additional benefit and $0.2 million is the additional cost.
To be precise, we can calculate the marginal benefit as the change in quantity sold divided by the change in advertising expenditures. For example, the marginal benefit between $1.2 million and $1 million is (9 million - 8 million) / ($1.2 million - $1 million) = 10 million units per million dollars.
The firm should continue advertising until the marginal benefit becomes equal to the marginal cost. In this scenario, with a constant marginal cost of $4, the firm should continue advertising until the marginal benefit (10 million units per million dollars) is equal to 4 million units per million dollars, which is equivalent to an additional benefit of 1 million units for an additional cost of $0.25 million. Therefore, the firm should continue advertising until the advertising expenditure reaches approximately $1.25 million.
The economic principle used in making this decision is the principle of marginal analysis, which involves comparing the additional benefit with the additional cost to find the optimal level of a particular activity.