13-1. Under what conditions may a firm expect ceteris paribus conditions to hold for changes in its advertising and promotional expenditures?
13-2. Discuss the idea of a minimum threshold of advertising and promotional effectiveness. Is it reasonable to argue the existence of such a threshold?
13-3. Why should we expect diminishing returns to (eventually) apply to advertising and promotional efforts? Outline several reasons.
13-4. What is the rule for optimal advertising expenditure in the short run, given price and average variable cost levels? Explain.
13-5. Outline the process underlying the simultaneous selection of the optimal level of advertising and the optimal price.
13-6. Why do oligopolists face a “prisoner’s dilemma” problem when it comes to deciding on the level of advertising expenditures?
13-7. If firms decided to limit their advertising expenditures to a given amount, would market shares then remain stable at the present levels? Why or why not?
13-8. Outline the issues involved in attempting to predict the impact of an advertising or promotional campaign.
13-9. If there are residual impacts in future periods from this period’s advertising expenditure, is it necessarily excessive to spend beyond the point where short-run incremental cost of advertising exceeds short-run incremental revenue from advertising?
13-10. Outline the issues involved in the argument that advertising and promotional expenditures raise the product differentiation barriers to entry. Would these barriers exist without advertising’ Why?
PROBLEMS AND SHORT CASES
13-1. The Thompson Textile Company has asked you for advice as to the optimality of its advertising policy with respect to one of its products, product X. The following data are supplied:
Sales (units) 282,500
Advertising elasticity of demand 2.50
Price per unit $ 2.00
Marginal cost per unit is constant at $ 1.00
Advertising budget for product X_ $ 56,000
(a) Is Thompson’s advertising budget for product X at the profit-maximizing level?
(b) If not, can you say how much more or less it should spend on advertising? Discuss all relevant issues and qualifications you think are important.
13-2. The McWilliams Bottling Company bottles and markets under license a major brand-name soft drink. Prices of soft drinks are virtually dictated by the market and the preponderance of dispensing machines that require a time-consuming adjustment in order to allow price changes to be effected. In the regional market that it serves, McWilliams has noticed that quantity demanded responds to variations in the level of advertising and promotional expenditures. The firm has kept the following records of sales (units) and advertising and promotional expenditures over the past two years:
Last Year | Sales (units) | Advertising/ Promotion ($) |
1st quarter | 96,000 | 3,400 |
2nd quarter | 103,000 | 4,350 |
3rd quarter | 93,000 | 3,750 |
4th quarter | 111,000 | 5,900 |
Preceding Year | ||
1st quarter | 90,000 | 2,600 |
2nd quarter | 76,000 | 1,850 |
3rd quarter | 104,000 | 5,200 |
4th quarter | 120,000 | 7,300 |
McWilliams’s present advertising and sales (units) levels are $4,000 and 99,500 units. Contribution margin (per unit) is considered to be constant at $0.22. The marketing department at McWilliams feels that there were no significant changes in any factors that would prevent the above data from being used to reliably estimate the firm’s sales/advertising function.
(a) Plot the sales data against the advertising expenditures and sketch in what appears to be the line of best fit to the data.
(b) Please advise McWilliams as to the estimated optimal level of its advertising and promotional expenditures. Explain and defend your recommendation.
13-3. Flintrock Fixtures is a small partnership that produces and markets a variety of kitchen and bathroom fixtures in ceramics, metal, and marble. The market for these products in Flintrock’s area is not highly competitive, since the rival firms tend to compete in separate market segments of the fixtures market. Over the past year, one of the major partners, Charles Flint, has been experimenting with advertising and promotional levels in order to ascertain the impact of this variable on sales. Regressing monthly sales revenue against monthly advertising and promo-
tional expenditures, Mr. Flint has obtained the following regression equation: TR = 110,482.5 + 2318.6/1 — 103. 2A 2 , where TR represents sales revenue in dollars and A represents advertising and promotional expenditures in thousands of dollars. This equation was derived from data ranging from $1,000 to $8,500 spent per month on advertising and promotion. ( R 2 = 0.99, significant at the 1 percent level.) The present level of advertising and promotional expenditure is $6,000 per month, and Mr. Flint, who wishes to maximize sales revenue, wishes to increase this expenditure to $7,500 per month, which is the maximum that Rocky Spinelli, the other major partner, will agree to.
A minor partner in the enterprise, Peter Pebble, is concerned with the short-term profits of the enterprise. Fie argues that given the firm’s pricing policy of marking up average variable costs by 100 percent, monthly profits would be increased significantly by reducing advertising and promotional expenditures. Mr. Pebble argues that a reduction of at least $2,000 per month would augment profits considerably.
Another minor partner, John Stone, argues that the longer-term profitability of the enterprise is the appropriate objective to pursue and that he supports Mr. Flint.
(a) What level of expenditure on advertising and promotion would maximize monthly sales revenue, given no limit on this level? How confident are you about the accuracy of this prediction? Explain.
(b) What level of expenditure on advertising and promotion would maximize monthly profits? Explain.
(c) Make an argument to support Mr. Stone’s position.
(d) Presuming Mr. Stone to be correct in his reasoning and Mr. Pebble to be outvoted, what do you suggest Flintrock do?
13-4. Record Breakers is a downtown store selling phonograph records and tapes. Its nearest competitor is about six blocks away, and its clientele is composed almost entirely of downtown office workers and other personnel from nearby buildings. Record Breakers has found that the sales of phonograph records vary with the number of records it places on special at $3.99 (compared with the regular price of $6.99) and with the space purchased in the city’s morning newspaper for advertising these specials. The specials are intended to attract customers into the store where they will (it is hoped) also purchase one or more other records at the regular price. The greater the number of specials offered, the lower the total revenue per record, or average price of the records sold. Given any specific number of records on special, the store finds that record sales vary positively, but with diminishing returns, with the area devoted to advertising these particular records in the newspaper. Regression analysis indicates that
Q = 624.3 - 216.52 P + 481.85 - 35.85A 2
where Q represents the weekly sales (units) of albums; P is average price in dollars; and S is space units (100 square inches daily for five days) in the morning newspaper. This regression equation is highly significant and explains virtually all the variation in weekly record sales.
The average variable cost per record is constant at $3 and space units in the newspaper cost $300, and this space is available in continuously variable fractions of a unit. The “average” situation is that Record Breakers will place six records on special and buy 2.5 units of advertising space each week. This combination causes the average price to be $5.75 over all records sold. The relationship between average price and number of records on special has been estimated as Av.P = 6.93 — 0.19 NS (with R 2 = 0.97, significant at the 5 percent level) over the range of one to fifteen records on special. This relationship holds independently of the units of advertising space purchased, although the latter does influence volume, as indicated by the earlier regression equation.
(a) Using graphical analysis, find the level of average price and the level of advertising space purchased that allow short-run profit contribution to be maximized.
(b) How many records should be put on special each week? Explain.
13-5. Vincenzo Pizzeria Limited operates the only pizza place in town although there are several other fast-food outlets in peripheral competition with Vincenzo. The manager, Vincenzo Fiorelli, feels that he has a virtual monopoly, since his clientele is largely comprised of fervent pizza lovers, and that selling more pizzas is just a matter of inducing people to “eat out” more often. Consequently Mr. Fiorelli holds prices constant and advertises in local newspapers and on a local television. His pizzas come in three sizes and with a variety of toppings, from “plain (tomato paste and cheese) all the way up to “deluxe” (mushrooms, peppers, olives, ground beef, pepperoni, and heaps of mozzarella cheese).
Mr. Firorelli’s son Paolo has recently obtained his business degree and has joined the family business as marketing manager. Paolo is interested in maximizing profits of the enterprise, since his father has promised him half of any extra profits generated as a bonus. Paolo decides to conduct an analysis of the cost and demand conditions facing the firm. First he examines the cost structure. Given the three different sizes of pizza and the various combinations of toppings, the firm is in effect offering a very broad product line. Paolo’s first task is to convert all the product offerings into the terms of a common denominator, which he calls a medium- pizza equivalent (MPE). The weights attached to each product reflect the relative variable costs of that product. Thus a medium-deluxe pizza is equal to 1 MPE, a small-deluxe pizza is equal to 0.75 MPE and a large-deluxe is equal to 1.5 MPEs, with lower weights given in each size category where the pizza is less than deluxe. The average variable cost of an MPE is $2.65, and Paolo finds this to be constant in the relevant output range. The first major decision Paolo makes is to standardize prices on all pizzas by marking up the average variable cost by 50 percent.
The marketing manager then undertakes a study of demand conditions. After examining past records and interviewing a random sample of five hundred customers and potential customers, Paolo generates the following demand function for Vincenzo’s pizzas:
Q = 28105.1 - 5842.2 P + 1061.6/4 - 22.5A 2
where Q is the number of MPEs demanded per month; P is the price of an MPE in dollars; and A is the advertising and promotional expenditures per month in thousands of dollars.
At present, prices are as indicated by the above markup-pricing policy, and advertising and promotional expenditures are running at the rate of $8,000 per month.
(a) Using graphical analysis (with algebraic confirmation of results), find the optimal price and advertising/promotional levels.
<b) How much will Paolo’s monthly bonus be? (State all qualifications and assumptions, if any, underlying your answers.)
13-6. The Silk Purse Cosmetics Company operates in close competition with several other major suppliers of cosmetics and toiletries. In this market, consumers do not seem to be very price conscious: If they believe a product will help them, they tend to buy that product as long as its price lies below a limit that the consumer considers intolerable. Consequently, Silk Purse and its rivals tend to compete through their advertising and promotional expenditures, which are typically aimed at informing consumers of the virtues of their new and established products. Silk Purse’s advertising and promotion budget is $25 million for this year, and it estimates that its rivals will collectively spend about $100 million this year. Silk Purse’s net profits are projected to be $2.8 million this year.
The vice-president of finance is worried that the expected profits this year will not be high enough to support the continuation of Silk Purse’s research and development program, given that dividends, taxes, and managerial bonuses must be paid out of profits. He suggests that a reduction of advertising to around $20 million would cause the profit situation to improve.
The vice-president of marketing argues that a reduction in the advertising budget to $20 million would cause sales to drop by $10 million, meaning a $1.7 million dollar reduction in net
13-7.
13-8.
profits. On the contrary, she says, Silk Purse should increase advertising and promotional expenditures to $30 million. This action will increase sales by $8.5 million and net profits by $1.2 million.
The president of Silk Purse, M. C. Hogg, fears that an increase in advertising and promotional expenditures of this magnitude will very likely cause a competitive reaction from the major rivals. You are called in to advise Mr. Hogg.
(a) With the aid of a payoff matrix, explain the vice-president of marketing’s argument to Mr. Hogg.
(b) How does Mr. Hogg’s assessment of the situation differ from that of the marketing vice- president?
(c) What information would you encourage Mr. Hogg to obtain before making his decision? The automobile-manufacturing industry has three major domestic producers, one minor and several minuscule domestic producers, and several major foreign producers, each supplying vehicles to the North American market. Advertising and promotional expenditures constitute a large part of the competitive effort in this industry, once the product design and price levels have been determined for each model year. With a major purchase like an automobile, the potential purchaser must feel confident about the quality of the vehicle, the efficacy of aftersales seivice, and the future value of the automobile at trade-in time. Advertising campaigns typically stress these factors and are also aimed at reducing postpurchase dissonance and building brand loyalty.
Suppose you are the advertising manager of one of the very small domestic auto producers. Your company’s sales have been hovering perilously around one-fortieth of one percent of the entile market. Your advertising budget is $1.5 million, and your projected net profits before taxes are less than $5 million. Your advertising budget represents 10 percent of sales revenue, compared with an industry average of 7.5 percent. Net profits are low, largely because of your relatively short production runs, which do not allow overheads to be amortized over large output levels.
(a) Prepare an argument to convince the marketing vice-president that your advertising budget should be increased. Include counterarguments to his probable objections in your proposal
(b) Outline the information you would want the marketing research department to obtain before planning your major campaigns for this year.
Concord Microwave Systems, Inc., manufactures and markets radar detectors. Their original product, the Diplomat, had been the industry standard of excellence for several years, until their new miniaturized version, the Ambassador, was introduced three years ago. This smaller version now sets the standards that the other manufacturers try to meet. Sales have been strong trom its introduction, but the management of Concord is considering whether or not the advertising budget should be increased. They currently spend only $180,000 per annum, mostly in auto magazines, on advertising and promotion. They prefer to keep a relatively low profile rather than stir up opposition to radar detectors. Nonetheless, they feel that they could increase their advertising budget by about a third without raising significant opposition to their product.
Based on monthly sales and advertising data collected over the past two years Concord’s marketing research department has estimated the sales-advertising function for its miniature radar detector to be Q = 49,973.4 + 16.11M - 0.0115/1’, where Q represents units of quan- tity demanded, and A represents thousands of dollars spent on advertising. The price has been $295 ever since the introduction of the Ambassador model, and its average variable cost of production has stabilized at $200 per unit regardless of volume produced, within reasonable units. Concord s total fixed costs amount to $2.5 million per annum, excluding advertising.
(a) Calculate the current output, total revenue, and total profit levels, based on the sales-adver- tising function.
(b) What is the profit-maximizing level of advertising?
(c) Calculate the output, revenue, and profit levels that Concord might expect if advertising expenditure was adjusted to the profit-maximizing level.
(d) State any assumptions and qualifications that underlie your analysis.
13-9. Meghan Alexandra Perfumes, Inc., manufactures a product line of exotic perfumes which are marketed worldwide. Sales of this perfume have been very strong, approaching a quarter of a million ounces in each of the first two years. Based on quarterly sales and advertising data Meghan has estimated the dependence of sales volume on advertising expenditures as follows:
Q = 52,833.98 + 248.358A - 0.049M 2
where Q is ounces of the perfume, and A represents thousands of dollars spent annually on advertising. For the current year the advertising budget has been set at $950,000, over the objections of the marketing vice-president, who feels that it should be substantially higher than that. Meanwhile, others in the strategy group claim that it is already too high and simply wasteful. The wholesale price of the perfume is $9.99, and the marginal cost of production is constant at precisely one-third of that. Overheads allocated to this product amount to $400,000 per annum, not including the advertising expenditure.
(a) At the planned level of advertising, and given the same price and cost situation, what will be the quantity demanded and the total profit for this line of perfumes?
(b) What is the profit-maximizing level of advertising expenditures?
(c) Is there a significant gain in revenues and profits available by adjusting advertising expenditures to a higher level?
(d) What assumptions and qualifications underlie your answers?
13-10. Andrew Evans, Inc., produces and sells toys for babies and toddlers, and the firm has enjoyed considerable success in the past few years as the post-World War II "baby boomers have made their own baby boom in the 1980s. Sales nationwide edged past the $4 million mark last year, and this year the president of Andrew Evans has set aside $1 million for advertising, up from $750,000 last year. The firm sells a variety of products, but it is a sufficient approximation to think in terms of an “average” product with an average price of $16 and marginal cost constant at $8 per “average” unit. The firm’s overheads are $800,000 per annum, excluding advertising.
Market research has culminated in the following estimate of the firm’s sales-advertising function:
Q = 110,386.3 + 298.674A - 0.10537A 2
where Q represents the units of the “average” product, and A represents thousands of dollars spent on advertising.
(a) Calculate the expected sales volume and total profit given an advertising budget of $1 million.
(b) Calculate the profit-maximizing level of advertising expenditure.
(c) At that level, what would sales volume, revenue, and profit be?
(d) What reasons can you think of for supporting the president’s decision to spend $1 million on advertising?
SUGGESTED REFERENCES AND FURTHER READING
Ayanian, R. “Advertising and Rate of Return,” Journal of Law and Economics, 18 (October 1975), pp. 479-506.
542
Topics in Managerial Economics
Brush, B. C. “The Influence of Market Structure on Industry Advertising Intensity,” Journal of Industrial Economics, 25 (September 1976), pp. 55-67.
Clarke, D. G. “Sales-Advertising Cross-Elasticities and Advertising Competition,” Journal of Marketing Research, 10 (August 1973), pp. 250-61.
Comanor, W. S., and T. A. Wilson. “The Effect of Advertising on Competition: A Survey,” Journal of Economic Literature, 17 (June 1979), pp. 453-76.
Cubbin, J. S. “Advertising and the Theory of Entry Barriers,” Economica. 48 (August 1981) pp. 289-98.
Dorfman, R., and P. O. Steiner. Optimal Advertising and Optimal Quality,” American Economic Review, 44 (December 1954), pp. 826-36.
Freidman, J. W. “Advertising and Oligopolistic Equilibrium,” Bell Journal of Economics, 14 (Autumn 1983), pp. 464-73.
Kotler, P. Marketing Management (4th ed.), chaps. 7, 15, and 16. Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1980.
Leffler, K. B. Persuasion or Information? The Economics of Prescription Drug Advertising,” Journal of Law and Economics, 24 (April 1981), pp. 45-74.
Needham, D. “Entry Barriers and Non-Price Aspects of Firms’ Behavior,” Journal of Industrial Economics, 25 (September 1976), pp. 29-43.
Nerlove, M., and K. J. Arrow. “Optimal Advertising Policy under Dynamic Conditions,” Economica, May 1962, pp. 129-42.
Peles, Y. “Rates of Amortization of Advertising Expenditures,” Journal of Political Economy 79 (September-October 1971), pp. 1032-58.
Primeaux, W. J., Jr. “An Assessment of the Effect of Competition on Advertising Intensity ” Economic Inquiry, 19 (October 1981), pp. 613-25.
Rao, V. R. “Alternative Econometric Models of Sales-Advertising Relationships.” Journal of Marketing Research, 9 (May 1972), pp. 177-81.
Scherer, F. M. Industrial Market Structure and Economic Performance (2nd ed ) chap 14 Chicago: Rand McNally & Company, 1980.
Schmalensee, R. Advertising and Profitability: Further Implications of the Null Hypothesis ” Journal of Industrial Economics, 25 (September 1976), pp. 45-54.
Schmalensee, R. The Economics of Advertising. Amsterdam: North-Holland Publishing, 1972.
Schmalensee, R. “Advertising and Entry Deterrence: An Exploratory Model,” Journal of Political Economy, 91 (August 1983), pp. 636-53.
Simon, J. L. Applied Managerial Economics, chap. 7. Englewood Cliffs, N.J.: Prentice-Hall Inc., 1975.
Spence, A M. “Notes on Advertising, Economies of Scale, and Entry Barriers,” Quarterly Journal of Economics, 95 (November 1980), pp. 493-507.
TeNer, L. “Advertising and Competition,” Journal of Political Economy, December 1964,
Wiggins, S N., and Lane, W. J. “Quality Uncertainty, Search, and Advertising,” American Economic Review, 73 (December 1983), pp. 881-94.