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Keith Siilats R11

1. Why do firms advertise?


In free market price is determined by demand and supply. The production takes place on quantity where demand equals supply, that amount is produced and sold. This is described below:

Goods are sold at price p and quantity q is sold. Demand equals supply at point E which is called equilibrium, because there is no reason for change. Anyway it can happen that either the demand or supply curve shifts due to some reasons. Those reasons for demand are the change in income, prices of other goods (complement and substitutes), change in population, legislation or in fashion and the amount of advertising. If any of those moves in favor (income rises, more advertising etc.) the demand curve shifts right and new equilibrium is set. This is shown below:

As seen the new equilibrium quantity q is bigger than old q and the new price p is bigger than the old p. So that means that the firms can now sell more with higher price, so it is very profitable for them when some of the conditions of demand moves in favor. As it is very difficult to change income, population or any other factor but advertising, they advertise to increase demand.

Anyway firms can also decrease price to extend demand, but that sometimes "eats" more profits than advertising. There are also number of markets dominated by few big firms (oligopolies), which advertise most, but almost never decrease prices. This is explained by the game theory, if firm decreases the price the other firms do it as well, so the firm would not increase its sales very much. If firm increases its price the other firms would not do that and firm will lose its clients. So the demand curve is kinked. It is shown below with marginal cost (MC) curve and marginal revenue(MR) curve that has twice the steep as demand does:

As seen it is not reasonable for firm to change its price. The production always takes place where MC=MR and advertising increases MC, but as there are discontinuity in MR curve, the price remains the same. That is why oligopolies can advertise and still keep the price same (Mars advertises and even increases the size of its products without increasing the price). Otherwise the same thing applies to oligopolies: they still advertise to make the demand curve shift right and so to increase their quantity sold.

The second type of firms which advertise their products much are firms in markets with monopolistic competition. The product of each firm is differentiated from that of rivals in that type of market. All the firms try to develop the loyalty to their brand, the easiest and most used way of doing this is by advertisements, so one more reason why firms advertise is to develop the brand loyalty. The short run equilibrium for firms at that industry is:

Demand curve is downward sloping, because if firm increases its output it will lose some, but not all of its customers. Firm produces where MC=MR, so at point B, right now AC=/=AR so industry is not in equilibrium. In short run some abnormal profits cab be made (cpab). Anyway there is free entry to the market so new firm enter the market and AR curve pivots clockwise, also new firm bid up the price of factors and firms will increase advertising money which both causes AC curve to increase. The same thing opposite around happens in loss making circumstances as well, so long run equilibrium for firm will be:

As seen no abnormal profits are made and industry is not in equilibrium (AC=AR), it is not still very efficient market, because production never takes place at the lowest point of AC.

2. Critically discuss the view that advertising promotes imperfections and is against the interest of the consumer.


Advertising is producers' action aimed to customers to increase the demand (to make their product sell more), but of course the advertising cost must be paid for consumers. Obviously if firm wants to increase the demand for its product it is not satisfied with the present demand. There can be numerous reasons for that.

Firstly if the product is new or it has some new features (e.g. uses less energy, lasts longer) that have been innovated. The demand for this product is low because consumers do not know the product and its new features. In this case it is for the interest of consumers to advertise. Both firm and consumers benefit from that: firm by increasing its sales (and if the advertising was not enormously expensive also its profits), consumers benefit by having the better product, which e.g. uses less energy etc. In that case it is called informative advertising and it is profitable at the end for consumers to pay the price of advertising. In general this type of advertising increases consumers' sovereignty.

Second type of advertising is called persuasive advertising. This does not contain or contains little information about product itself, the main idea is to persuade consumer to buy the product that means to decrease their sovereignty and promotes imperfections. This type of advertising is usually very expensive and the price of the product being advertised is also expensive (in washing powder ca. 25% of the price is sometimes spend on advertising). This type of advertising is generally against the interest of consumers. They could make the decision of which product to buy without persuasive adverbs. The Government has already taken actions against persuasive advertising by putting laws on tobacco adverbs and so on. The reason persuasive adverbs are not totally declined is that the money spend by firms can finance commercial TV and newspapers, without them e.g. newspapers will cost much more. So persuasive advertising in reality is not totally against interests of the consumer.

In general advertising creates imperfections and wastes much money. But although it is in some cases against the interest of the consumers the profit it generates for consumers turns out to be bigger. No commercial can actually force consumers to buy something, but it has an extremely important exercise of informing people.

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