You have just received a proposal from the marketing department that your firm\'

Question

You have just received a proposal from the marketing department that your firm's advertising budget should be increased by 20% from its current level of $250,000.  The marketing department feels the proposed increase will stimulate sales and enhance profits.  You are currently selling 200,000 units at a price of $5 per unit and your total cost function is given below.  Given an advertising elasticity of .4 and the total cost function below, answer questions A, B and C:

TC = 300,000 + 2q +A where A = Advertising expenditures and q = the number of units produced.

A)  How many extra units will be sold as a result of the increase in advertising expenditures? (3 points)

B)  What is the additional revenue and additional cost, the change in your revenues and costs, if the advertising budget is increased? (3 points each)

(C)  If advertising expenditures are increased as proposed what will be the change in the firms profit level?        

(3 points)

D) Should you accept the proposal if your goal is to maximize short run profits?  (1 point)

NOTE: When you are asked to forecast a quantity resulting from a change in a variable you may use the definition of elasticity, the easy method, to derive the forecast for all problems. Using the definition is less accurate than using the elasticity formula but much easier mathematically.

Explanation / Answer

elasticity = % change in quantity/%change in advertising

0.4 = [(q-200000)/200000]/0.2

0.4*200000*0.2 = q-200000

q = 216000

extra units = 216000-200000 = 16000

additonal revenue = 16000*$5 = $80000

additional cost = 2*16000 + 0.2*250000 = $82000

change in profit levels = change in reveneue-change in cost = $80000-$82000 = -$2000

as the profit decreased by $2000, the proposal shall not be accepted.

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