Question

2. 5 pts. Under the guidance of a good manager, a monopolistically competitive firm spends an optimal amount of its revenues on advertising. Last month the firm spent $2,000 of its $10,000 revenues on advertising. If its advertising elasticity was 0.5, what was this firm's price elasticity demand? Does this make the firm's demand elastic, unit elastic or inelastic?

Answer 1

Answer 2

Profit maximizing advertising condition :

Advertising expenditure / Sales = advertising elasticity / absolute value of Price elasticity of demand

Here it is given that Advertising expenditure = 2000 , Sales = 10,000, advertising elasticity = 0.5

=> 2,000 / 10,000 = 0.5 / absolute value of Price elasticity of demand

=> absolute value of Price elasticity of demand = 5*0.5 = 2.5

As elasticity of demand is negative we have Price elasticity of demand = -2.5

Monopolistic competitive uses Advertising in order to promote there differentiated product so that they get the more market power and hence if they increase there prices, there demand will not get affected to such an extent. Thus This means responsiveness of demand to change in price decreases and hence Price elasticity of a firm will decrease.

Hence, This advertising makes firm's demand relatively inelastic but here as absolute value of elasticity of demand is greater than 1, this means that demand is elastic.

Thus, Now demand is elastic but this advertising made demand relatively less elastic or relatively more inelastic.