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

A life insurance company's marketing head argues that the firm should keep increasing advertising as long as it raises sales. Using the Dorfman-Steiner logic, the correct reply is that the firm should expand advertising until:

The firm should advertise until the additional margin from extra sales equals the additional advertising outlay. This marginal condition maximises profit; continuing merely because sales rise would add more cost than margin and reduce profit.

  1. AAdvertising spending equals total profit
  2. BSales revenue stops rising in absolute terms
  3. CThe extra gross margin earned from the additional sales just equals the extra advertising costCorrect
  4. DAverage advertising cost is minimised
  5. The advertising elasticity of demand equals one

Explanation

Profit maximisation requires marginal benefit equals marginal cost: the extra margin (P-MC) on added sales equals the rupee of extra advertising. Merely raising sales is insufficient, since spending beyond this point reduces profit.

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