Question

Jordan Enterprises has estimated the contribution margin P−MCPP−MCP for its Air Express model of basketball shoes to be 40 percent. Based on market research and past experience, Jordan estimates the following relationship between the sales for Air Express and advertising/promotional outlays:

Advertising/Promotional Outlays	Sales Revenue
($)	($)
500,000	4,000,000
600,000	4,500,000
700,000	4,900,000
800,000	5,200,000
900,000	5,450,000
1,000,000	5,600,000

What is the marginal revenue from an additional dollar spent on advertising if the firm is currently spending $1,000,000 on advertising?_

What level of advertising would you recommend to Jordan’s management? (800,000, 600,000, 1,000,000, 900,000, 500,000, or 700,000    .

Answer 1

1.          Revenues increase by $150,000 when advertising expenditures increase from $900,000 to $1,000,000. Hence the marginal revenue from an additional dollar spend in advertising is $1.50, which is dTR/dA. An estimate of the advertising elasticity at $1,000,000 outlays is E_a = (dSales/dA)(A/Sales) = (1.5)(1,000,000/5,600,000) = .268. At $900,000 outlays, E_a = .413.

2. Advertising Outlays       Sales Revenues      MR/$Advertising

                     $500,000                  $4,000,000               -

                       600,000                    4,500,000        $5.00

                       700,000                    4,900,000          4.00

                       800,000                    5,200,000          3.00

                       900,000                    5,450,000          2.50

                    1,000,000                    5,600,000          1.50

Equation shows that the “advertising intensity” should be expanded up to the product of the contribution margin times the elasticity of advertising. Ak/PQ = [(P-MC)/P] E_a. At $900,000 outlays, the product on the right hand side is (40%)(.413) = 16.52%. The share of total revenue spent on advertising of Jordan shoes is also $900,000/$5,450,000 = 16.51%. Assuming that price and marginal cost are constant over the various ranges of advertising outlays, Jordan should spend $900,000 on advertising.