432 PART • Market Structure and Competitive Strategy the advertising and price elasticities of demand Given information (from, say, market research studies) on these two elasticities, the firm can use this rule to check that its advertising budget is not too small or too large To put this rule into perspective, assume that a firm is generating sales revenue of $1 million per year while allocating only $10,000 (1 percent of its revenues) to advertising The firm knows that its advertising elasticity of demand is 2, so that a doubling of its advertising budget from $10,000 to $20,000 should increase sales by 20 percent The firm also knows that the price elasticity of demand for its product is −4 Should it increase its advertising budget, knowing that with a price elasticity of demand of −4, its markup of price over marginal cost is substantial? The answer is yes; equation (11.4) tells us that the firm’s advertising-to-sales ratio should be −(.2/−4) = percent, so the firm should increase its advertising budget from $10,000 to $50,000 This rule makes intuitive sense It says firms should advertise a lot if (i) demand is very sensitive to advertising (EA is large), or if (ii) demand is not very price elastic (EP is small) Although (i) is obvious, why should firms advertise more when the price elasticity of demand is small? A small elasticity of demand implies a large markup of price over marginal cost Therefore, the marginal profit from each extra unit sold is high In this case, if advertising can help sell a few more units, it will be worth its cost.22 E XA MPLE 11.6 ADVERTISING IN PRACTICE In Example 10.2 (page 370), we looked at the use of markup pricing by supermarkets, convenience stores, and makers of designer jeans We saw in each case how the markup of price over marginal cost depended on the firm’s price elasticity of demand Now let’s see why these firms, as well as producers of other goods, advertise as much (or as little) as they First, supermarkets We said that the price elasticity of demand for a typical supermarket is around −10 To determine the advertising-to-sales ratio, we also need to know the advertising elasticity of demand This number can vary considerably depending on what part of the country the supermarket is located in and whether it is in a city, suburb, or rural area A reasonable range, 22 however, would be 0.1 to 0.3 Substituting these numbers into equation (11.4), we find that the manager of a typical supermarket should have an advertising budget of around to percent of sales—which is indeed what many supermarkets spend on advertising Convenience stores have lower price elasticities of demand (around −5), but their advertising-to-sales ratios are usually less than those for supermarkets (and are often zero) Why? Because convenience stores mostly serve customers who live nearby; they may need a few items late at night or may simply not want to drive to the supermarket These customers already know about the convenience store and are unlikely to change their buying habits if the store Advertising often affects the price elasticity of demand, and this fact must be taken into account For some products, advertising broadens the market by attracting a large range of customers, or by creating a bandwagon effect This is likely to make demand more price elastic than it would have been otherwise (But EA is likely to be large, so that advertising will still be worthwhile.) Sometimes advertising is used to differentiate a product from others (by creating an image, allure, or brand identification), making the product’s demand less price elastic than it would otherwise be