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

A monopolistically competitive firm selling mutual fund services advertises successfully. In the long run, with free entry, what is the most likely result for the firm?

With free entry in monopolistic competition, supernormal profit gained from advertising attracts rivals whose entry shifts demand back until only normal profit remains. The firm's average cost is higher because of advertising spend, and it still produces below the efficient minimum-cost output.

  1. ASupernormal profit persists because advertising shifts demand permanently
  2. BDemand shifts right, but entry of rivals shifts it back until only normal profit is earned, with higher average cost due to advertisingCorrect
  3. CThe firm produces at the minimum of its long-run average cost curve
  4. DThe firm becomes a price taker facing a horizontal demand curve
  5. The firm earns a loss permanently as advertising cost exceeds revenue

Explanation

Advertising raises demand and profit initially, but free entry and imitation erode demand until the firm earns normal profit. Advertising costs raise average cost, and output stays below the minimum-cost level (excess capacity).

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