IAI Actuarial Core Principles · Business Economics · Impact of advertising on sales and demand
A Bengaluru bank's credit card division has price elasticity of demand of -2 and advertising elasticity of demand of 0.5. Using the Dorfman-Steiner condition for profit maximisation, with advertising spend A and sales revenue R, what ratio of advertising to revenue is optimal?
The optimal ratio of advertising to revenue is 0.25. The Dorfman-Steiner condition sets it equal to the advertising elasticity divided by the absolute value of price elasticity, which is 0.5 divided by 2. Advertising should therefore be a quarter of sales revenue.
- AA/R = 0.25Correct
- BA/R = 0.5
- CA/R = 4
- DA/R = 1.0
- A/R = 0.10
Explanation
Dorfman-Steiner: A/R = advertising elasticity / absolute price elasticity = 0.5/2 = 0.25. Option 4 inverts the ratio. Option 0.5 uses only the advertising elasticity, ignoring the price elasticity.
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