Module No.3: Advertising and the theory of the firm
a) Using economic analysis and real world examples, explain why a firm may advertise its product.
Advertising has been defined as "any paid form of non-personal presentation and promotion of ideas, goods and services through mass media such as newspapers, magazines, television or radio by an identified sponsor." (http://www.tutor2u.net)
Why do firms advertise?
The most general answer is that firms advertise because they think it is profitable for them to do so. Firms spend money on promotional efforts if they believe that the benefits from that spending outweigh the costs (TR>TC).
Firms also advertise to achieve brand loyalty and to increase their sales (commercial advertisement). The graph below shows the effect of advertising on a product's demand curve. Demand D1 is the original demand before advertising with its equilibrium price P1 and the quantity Q1. However after a successful advertising campaign of the product the demand shifts from D1 to D2.
This is because the campaign attracts people's attention to the product. A demand shift to the right means that the firm can sell a larger quantity of the product at the same price, and therefore the firm makes higher profit.
This explicit example shows that the product must have improved its image, as the new demand D2 is relatively steep and therefore inelastic. Even if the firm increases the price from P1 to P2 the firm would still be able to increase its sales. The promotion somehow must have convinced the consumer, that the product of this brand is better then a substitute good of another firm. This simply increases people's desire to buy the product. The demand for substitute goods will therefore shift to the left.
Effect of advertising on the demand curve
Graph taken from: Essential Economics, John...