Question

(c) Advertising is widely used by monopolistically competitive firms. Discuss, with the aid of diagrams, how advertising can affect the firm’s pricing and output decisions. How much should a firm spend on advertising?

Answer 1

Price A firm in monopolistically competition produces a output that either minimize its losses or maximizes its profit. This level of output is established by the mutual interaction of the marginal revenue MR curve and marginal cost MC curve 16 MC ATC P1 ------ - iC 01 - 10 - - - - MR1 - Here the firm is selling pizzas. Figure 1 exhibits the effect of an advertisement that increases the demand for the product sold by the monopolistically competitive firm. With advertising, demand shifts from D to D1 and marginal revenue shifts from MR to MR1. The new quantity, determined by the interaction of MR and MC, is shown by Q1. Figure 1 shows that the new quantity Q1 is higher than the original quantity which is 150 pizza per day. The price charged by the pizza maker is also increased from $13 per pizza to P1. Hence, advertising increases the price charged and volume of pizza sold by the firm. - - 150 Q1 200 Quantity Figure 1: Monopolistically competitive firm and profit maximization Optimum amount of advertising can be sought by using a rule that indicates that the advertising to sales ratio should be equal to the ratio of advertising elasticity of demand to own price elasticity of demand. If this is ensured, then advertising amount will be optimum