9/22/11

How advertising affects supply and/or demand


Advertising spending is one of those ambiguous areas of supply and demand theory where we don't really know exactly what will happen but we can make a pretty good guess.  Our first guess would be that advertising affects consumer's tastes and preferences in a positive way, and that this will result in an increase in demand (the demand curve will shift up/right).  But advertising also costs firms money.  The distinction we have to keep in mind is whether or not advertising affects the marginal cost of production, or whether their advertising budget is fixed.  The difference between these two methods decides whether or not the supply curve will shift.

 But first let's focus on shifting of the demand curve.  Imagine that there is a product that you are not familiar with, or that you do not have enough information about to justify purchasing it.  For this example, we can think of computers.  So maybe you go to a computer trade show and start looking around.  At these trade shows, you will see many trade show displays that contain information about products.  This information/advertising, if done correctly, will make you desire to purchase the product.  This means that you are experiencing a change in your tastes and preferences (in a positive way), and this results in an increase in demand.


Now we need to figure out whether or not the advertising will affect our supply curve.  Whether you know it now or not (depending on where you are at in the semester), the supply curve takes the shape of the marginal cost curve for the firm.  So if advertising affects marginal cost, then it will shift supply.  Imagine if the advertising took the form of new packaging, with either brighter colors, or perhaps an attached coupon.  Because every product would require this new packaging, it would affect marginal cost, and therefore would shift the supply curve left (a decrease in supply because cost of inputs went up).  On the other hand, imagine a company that printed a vinyl banner to display at your University.  That banner cost them a certain amount to make, and is not dependent on how many products are being sold.  So this type of advertising would not affect marginal cost, and therefore would not shift the supply curve.

So if advertising does not affect marginal cost, then we know for sure that equilibrium price and quantity will both rise (look at the first graph on the right, with only demand changing).  This is because only demand shifts, and since it increases we have more people buying the product which increases quantity demanded, and because firms are only willing to supply the increased amount at increased prices, the price goes up as well.  However, if both supply and demand shift, then we know for sure that equilibrium price will go up, but the answer for quantity is ambiguous.  Look at the graph below to see what I mean:

Our original equilibrium point is at point A.  If the supply curve shifts a little, to S'', then the new equilibrium occurs at point B and both price and quantity will rise.  If supply shifts a little more, to S', then the new equilibrium occurs at point C, and price rises, but quantity remains the same.  If supply shifts a lot to S''', then the new equilibrium occurs at point D, and price rises, but quantity falls.
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