Business Economics · Impact of advertising on sales and demand

Advertising, Market Structure and Welfare: Effects on Competition

Updated 11 October 2026 · Fact-checked

Advertising affects competition and welfare in two opposing ways. It can inform buyers, spur competition and build quality signals. It can also differentiate products, raise costs, create barriers to entry and push prices up. To answer exam questions, name the market structure, state both effects, then give a reasoned judgement.

Understand Advertising, Market Structure and Welfare

Start with the basic idea. Advertising is spending by a firm to shift demand for its product. In a perfectly competitive market there is little reason to advertise, because products are identical and each firm can sell all it wants at the market price. Advertising matters when products can be made to look different or when buyers lack information.

Under monopolistic competition, many firms sell differentiated products and entry is easy. Advertising is a tool of non-price competition. A successful advert makes demand for the firm's brand rise and become less elastic, because buyers see fewer close substitutes. In the short run the firm can earn supernormal profit. In the long run new firms enter and copy the strategy, demand for each firm falls back, and the firm earns only normal profit. The advertising cost is then part of average cost, so price ends up higher than it would be without advertising. Equilibrium is still at excess capacity: output is below the minimum of average cost.

Under oligopoly, a few large firms depend on each other's actions. Prices tend to be sticky, so firms compete with advertising, branding and product features instead. Advertising can become a prisoner's dilemma. If all firms advertise heavily, each spends more, and market shares may stay broadly unchanged. If all cut back, all gain. But each fears being left behind, so spending stays high. Firms may also collude tacitly on advertising levels.

Advertising can act as a barrier to entry. Established brands have built goodwill over years. A new entrant must spend heavily just to be noticed. Much advertising is a sunk cost: it cannot be recovered if the firm exits. This raises the risk and the scale of entry. Large firms also enjoy economies of scale in advertising, since the cost per customer reached falls as spending rises. This lets incumbents hold market power and earn supernormal profit for longer.

Now the welfare view. Benefits: it gives consumers information on price, quality and availability, lowers search costs, supports new product launches, may increase sales and so allow lower unit costs through economies of scale, funds media, and can signal quality. Costs: it can be persuasive rather than informative, creates brand loyalty and less elastic demand, raises average cost and price, can mislead, encourages wasteful spending that offsets rivals, and can create barriers that reduce competition. The net effect depends on the market and the type of advertising. Informative advertising tends to help welfare. Persuasive advertising is more likely to harm it. There is no single answer, so always argue both sides.

Key rules to remember

Long-run equilibrium, monopolistic competition: P = AC (including advertising cost) and MR = MC; Normal profit in the long run. Advertising cost is included in AC, so the price is higher than without advertising.
Advertising-to-sales ratio: Advertising ratio = advertising expenditure ÷ sales revenue; A high ratio suggests advertising is an important competitive tool or entry barrier. Interpret it with care, since it does not prove a barrier on its own.
Dorfman-Steiner condition: A ÷ R = e_A ÷ |e_P|; A is advertising spending, R is revenue, e_A is advertising elasticity of demand and e_P is price elasticity. It is a profit-maximising rule for a firm with market power. Revise it under optimal advertising spending.
Profit rule: Profit-maximising output where MR = MC; Advertising shifts demand and so changes MR. The rule itself stays the same.
Welfare test: Net welfare effect = benefits (information, lower search costs, scale economies) − costs (higher price, barriers, wasteful spending); A qualitative rule. Use it to structure the evaluation.

How to solve Advertising, Market Structure and Welfare questions

Use this method for any question on advertising, competition and welfare. It keeps your answer balanced and in the right order.

1Identify the market structure in the question: perfect competition, monopolistic competition, oligopoly or monopoly.
2State the role of advertising in that structure. In monopolistic competition it differentiates products. In oligopoly it is non-price competition.
3Explain the effect on demand: demand rises and becomes less elastic if advertising succeeds. Draw or describe the shift if the question asks.
4Describe the long-run result: supernormal profit is competed away in monopolistic competition, and advertising costs are in AC.
5Discuss the barrier-to-entry argument: sunk costs, brand loyalty and scale economies in advertising.
6Give the welfare benefits and costs for consumers and for society.
7Distinguish informative from persuasive advertising.
8Conclude with a judgement that depends on the market and the type of advertising.

Quickest way: Four-line balanced answer

When to use it: Use this for MCQs and short written parts when time is tight.

Line 1: name the structure and say what advertising does there.
Line 2: effect on competition (barrier or non-price rivalry).
Line 3: one benefit and one cost for consumers.
Line 4: judgement, linking to informative versus persuasive advertising.

Common mistakes in Advertising, Market Structure and Welfare

Saying advertising is always harmful or always beneficial.
Students remember one side of the argument.
Fix: Give both sides, then conclude that the effect depends on the market and the type of advertising.
Claiming monopolistic competition earns supernormal profit in the long run.
They stop at the short-run diagram.
Fix: Free entry removes supernormal profit. State that long-run profit is normal and AC includes advertising.
Treating advertising as a barrier to entry in every market.
It is taught as a general rule.
Fix: Say it can be a barrier, especially with sunk costs and strong brands. In monopolistic competition entry is still relatively easy.
Ignoring the prisoner's dilemma in oligopoly.
Students only discuss price competition.
Fix: Explain that all firms advertise, costs rise, and shares may barely change.
Confusing the effect on competition with the effect on welfare.
The two are linked, so they are blended together.
Fix: Treat them separately. Competition covers entry, rivalry and market power. Welfare covers consumer choice, price, information and efficiency.
Forgetting that advertising shifts demand and makes it less elastic.
Students focus on the shift only.
Fix: State both the rightward shift and the steeper demand curve, as this explains higher mark-up.

Worked examples

Example 1

Explain how advertising affects a firm in monopolistic competition in the short run and the long run.

Show the solution

Short run: advertising raises demand for the firm's brand and makes it less elastic, so the firm can raise price and earn supernormal profit.
Set output where MR = MC on the new demand curve. Price comes from the demand curve above that output.
Long run: supernormal profit attracts entrants offering similar products and advertising.
Demand for each existing firm falls and becomes more elastic until the demand curve touches the AC curve.
At this point P = AC, which includes advertising, so profit is normal.
The firm produces below the output at minimum AC (excess capacity), and price is higher than it would be without the advertising cost.

Answer: Advertising gives short-run supernormal profit by raising and steepening demand. In the long run entry removes it, leaving normal profit, higher average cost and excess capacity.

Example 2

Discuss whether advertising in an oligopoly is good for consumers and society.

Show the solution

State that oligopolists avoid price wars and use advertising and branding as non-price competition.
Benefits: consumers get information, lower search costs, awareness of new products, and possible quality signals. Media is funded. Higher sales can allow economies of scale.
Costs: heavy spending raises average cost and may raise price. It may be mostly defensive, as rivals match each other, leaving market shares similar.
It can create barriers to entry through sunk costs, brand loyalty and economies of scale in advertising, which protects market power.
Persuasive or misleading advertising can distort choice and encourage wasteful spending.
Judgement: informative advertising that helps entry and choice is beneficial. Persuasive, entry-deterring advertising is more likely to reduce welfare. The result depends on the industry.

Answer: The effect is mixed. Advertising brings information and possible scale gains, but also higher costs and barriers to entry. Welfare is likely higher when advertising is informative and lower when it is mainly persuasive or entry-deterring.

Exam tips

Always name the market structure first. Marks are tied to structure-specific points.
Use the words non-price competition, sunk cost, brand loyalty and barrier to entry. Examiners look for them.
For discussion questions, write both sides and a final judgement. One-sided answers lose evaluation marks.
If a diagram is asked for, show the demand curve shifting right and becoming steeper, then the long-run tangency with AC.
In MCQs, watch for absolute words such as always or never. They are usually wrong in this topic.

Practice questions from Impact of advertising on sales and demand

Advertising, Market Structure and Welfare in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

ACCA Strategic ProfessionalAdvertising and Marketing of Professional Services

Advertising, Market Structure and Welfare: frequently asked questions

Why is advertising common in monopolistic competition and oligopoly?

Products are differentiated, so firms can try to make their brand stand out. In oligopoly, firms often avoid price cuts because rivals would respond, so they use advertising as non-price competition.

How does advertising act as a barrier to entry?

Incumbents have built brand loyalty, and much advertising is a sunk cost. A new firm must spend heavily to compete, and large firms get cost advantages in advertising. This raises risk and discourages entry.

What is the difference between informative and persuasive advertising?

Informative advertising gives facts on price, quality and availability, and usually improves choice. Persuasive advertising tries to build loyalty and make demand less elastic. It is more likely to raise prices and reduce welfare.

Does advertising always raise prices?

No. It can raise average cost and price, but it can also increase sales and allow economies of scale, or increase competition by informing buyers. The effect depends on the market and the type of advertising.