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IAI Actuarial Core Principles · Business Economics · Impact of advertising on sales and demand

A large private life insurer in an oligopolistic market spends heavily on brand advertising, and smaller rivals cannot match this spending. Which argument best explains why such advertising may reduce welfare through market structure?

Heavy advertising by incumbents is a largely sunk cost that acts as a barrier to entry. Potential entrants must match it to compete, so fewer enter, and incumbents can keep prices above marginal cost and sustain abnormal profits, which reduces consumer welfare.

  1. AAdvertising costs shift the firm's demand curve left, lowering output
  2. BThe advertising expenditure is a sunk cost that can deter entry, allowing higher prices and abnormal profits to persistCorrect
  3. CAdvertising forces the firm to price at marginal cost
  4. DAdvertising always converts the oligopoly into perfect competition
  5. Advertising lowers the firm's fixed costs per policy to zero

Explanation

Heavy brand advertising is largely sunk and creates a scale advantage for incumbents. Entrants must spend similar amounts to build awareness, so entry is deterred. This lets incumbents sustain prices above marginal cost and earn abnormal profit, a welfare loss.

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