CFA Level I · CFA Level I Exam · The Firm and Market Structures
A monopolistically competitive firm launches heavy advertising for its differentiated product. Compared with no advertising, the most likely effect on the firm's cost and demand is that:
Advertising raises average total cost, but if it creates brand loyalty it can make the firm's demand less elastic, shifting it right and supporting a higher price. It does not make the firm a price taker or demand perfectly inelastic.
- Aaverage total cost rises, and demand becomes more elastic as it becomes a price taker
- Baverage total cost rises, and demand may become less elastic if advertising builds brand loyaltyCorrect
- Caverage total cost falls, because advertising always makes demand perfectly inelastic
Explanation
Advertising adds to fixed and average total costs. If it builds brand loyalty, it makes demand less elastic and can shift it right, allowing a higher price. If it also supports greater volume, average cost can eventually fall, but it does not make demand perfectly inelastic.
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