Optimal Level of Advertising

Advertising is one of the most common methods of nonprice competition. Others include personal selling, improvements in product quality, expansions in customer service, research and development, and so on. The profit-maximizing amount of nonprice competition is found by setting the marginal cost of the activity involved equal to the marginal revenue or marginal benefit derived from it. For example, the optimal level of advertising occurs at that point where the marginal revenues derived from advertising just offset the marginal cost of advertising.

The marginal revenue derived from advertising is measured by the marginal profit contribution generated. This is the difference between marginal revenue, MR, and the marginal cost of production and distribution, MCQ, before advertising costs:

Marginal Revenue _ Marginal Marginal Cost (11.3) Derived from Advertising Revenue of Output

The marginal cost of advertising, again expressed in terms of the marginal cost of selling one additional unit of output, can be written:

Marginal Cost _ Change in Advertising Expenditures of Advertising One-Unit Change in Demand

MC _ AAdvertising Expenditures _ AAd A ADemand AQ

The optimal level of advertising is found where

Marginal Revenue

_ Marginal Cost of Advertising

Derived from Advertising

MR MC _ AAdvertising Expenditures Q ADemand

In general, it will pay to expand advertising expenditures so long as MRA > MCA. Because the marginal profit derived from advertising is

(11.5) MnA = MRa - MCa the optimal level of advertising occurs at the point where

This relation is illustrated in Figure 11.7. As long as MRA > MCA, MnA > 0, and it will pay to expand the level of advertising. Conversely, if MRA < MCA, then MnA < 0, and it will pay to reduce the level of advertising expenditures. The optimal level of advertising is achieved when MRa = MCA, and MnA = 0.

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