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

A life insurer's marketing team finds that each additional rupee of advertising yields progressively smaller increases in policy sales, and eventually extra advertising adds almost nothing. Which statement best explains how this affects the firm's optimal advertising decision?

The firm should advertise until the extra revenue from the last rupee of advertising equals its extra cost. Because returns diminish but remain positive, spending beyond that point reduces profit, while stopping earlier forgoes profitable sales. Maximising sales alone is not the same as maximising profit.

  1. AThe firm should advertise until the marginal revenue from extra advertising equals its marginal cost, so spending stops well before sales stop respondingCorrect
  2. BThe firm should keep advertising until sales growth falls to zero, as total sales are then maximised and profit with them
  3. CThe firm should stop advertising as soon as the response begins to diminish, since returns are then negative
  4. DThe firm should set advertising so that average advertising cost is minimised
  5. The firm should advertise until advertising elasticity equals zero in all circumstances because profit then peaks

Explanation

With diminishing returns, profit is maximised where the marginal revenue from advertising equals its marginal cost. Going on until sales stop responding means spending beyond that point costs more than it earns. Diminishing returns are still positive returns, so stopping at once is wrong.

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