Question

Last month you assumed the position of manager for a large car dealership. The distinguishing feature of this dealership is its “no hassle” pricing strategy; prices (usually well below the sticker price) are posted on the windows, and your sales staff has a reputation for not negotiating with customers. Last year, your company spent $12 million on advertisements to inform customers about its “no hassle” policy, and had overall sales revenue of $45 million. A recent study from an agency on Madison Avenue indicates that, for each 6 percent increase in TV advertising expenditures, a car dealer can expect to sell 2 percent more cars—but that it would take a 1 percent decrease in price to generate the same 2 percent increase in units sold.

Assuming the information from Madison Avenue is correct, should you increase or decrease your firm’s level of advertising?

a. The firm should not change advertising.

b. The firm should increase advertising.

c. The firm should decrease advertising.

Answer 1

Price elasticity = % change in sales / % change in P = 2% / -1% = -2

Advertising elasticity = % change in sales / % change in advertising expenditure = 2% / 6% = 0.33

Profit maximizing advertising to sales ratio = Advertising elasticity / Price elasticity

Profit maximizing advertising to sales ratio = 0.33 / 2 = 0.165

This means the firm should spend 0.165% of its revenues on advertising.

This means (c) The firm should decrease advertising

Reason: The advertisement expenditure must be decreased and instead price must be changed to increase revenues