Question

In market 1, demand has an own price elasticity of -2.0 and an advertising elasticity of 1.5. In market 2, own price elasticity is -1.2, and advertising elasticity is 1.8.

A. In which market would you expect the largest markup of price over marginal cost? Explain

B. In which market would you expect the advertising budget relative to sales to be largest? Explain how you got your answer

Answer 1

(A)

The lower the absolute value of own-price elasticity of demand, the more inelastic the demand, so the higher the mark-up that a firm can charge. Since Market 2 has lower absolute value of own-price elasticity of demand (1.2 < 2), Market 2 will have higher mark-up.

(B)

Advertising elasticity is the ratio of percentage change in demand to a percentage change in advertising expense. The higher the advertising elasticity of demand, the higher the increase (decrease) in demand for a give increase (decrease) in advertising elasticity. Since Market 2 has higher advertising elasticity of demand (1.8 > 1.5), Market 2 will have higher advertising budget relative to sales.