Question

5. Using a graph, explain why a firm with market power might not want to spend money on advertising, even if such an expenditure would shift the firm’s demand curve to the right.

Answer 1

Firms may not want to spend money on advertising because the investment may not pay off. Though advertising may boost the demand of a particular product (especially if it is new rather than a mature product), it is also an expensive investment. Thus, the increase in revenues due to the ad campaign may just not be enough to compensate for the costs incurred with the campaign.

This decision then hinges on the expectations a firm has on what is going to be the impact on the sales volume and revenues. In the figure below, let D1 and MR1be demand and marginal revenue before advertising.

Assume the monopoly has a constant marginal cost with no fixed cost such that MC1 = AC1. Then, suppose the monopoly advertises and that the advertising shifts demand and marginal revenue to D2 and MR2. In particular, D shifts towards the right and becomes steeper (less elastic) because with advertising a firm is not only creating a taste for its good (which attracts more consumers and therefore shifts the curve) but also differentiating its product further from its competitors (so convincing the consumers that there are no good substitutes for your good).

Advertising raises costs. This increase in costs can be translated either through and increase in fixed costs or marginal costs.

Here in the diagram,

when the ad comes it shift MC from $4 to $8 also quantity increases as MR2 = MC2 at Q = 12 which was 8 earlier, it means quantity increases by 4 units .

price also rises from $12 to $16. means change in price = $4

It means the total revenue increase is $4*$4 = $16 [ Total revenue change = Price change*quantity change]

AC increases from $4 to $8 and quantity increase by 4

while total cost increases = change in AC ( as AC and MC is same here)multiplied by change in quantity = $4*4 =$16

It means profit increase by 16-16 = $0.

No use of advertising, so that's why a firm with market power might not want to spend money on advertising, even if such an expenditure would shift the firm’s demand curve to the right.