Question

Question 6 A firm in a monopolistic competitive market is thinking about taking on some big advertising or research & development projects. The projects are listed below. They currently sell 100 units, each of which costs $5 to make, for a price of $7. Which project would they take on? Explain your answers.

a. (5 points) An advertising campaign that would cost $100. It would double the amount of sold from 100 to 200. (The costs to make and price remain the same.)

b. (5 points) A research project that is expected to decreases the costs from $5 to $3. (Quantity and price would remain the same.) The project would cost $250 to implement.

c. (5 points) A Facebook marketing campaign that would make a product seem more valuable, allowing the firm to increase the price from $7 to $8 (with the quantity and costs to make remaining the same). The campaign would cost $150 to put into effect.

d. (5 points) A research & development project that would increase the demand for the product. The economists at the firm estimate that they could increase the price to $8 and also increase sales up to 150 units. (The costs to make would remain at $5.) The cost to come up with this new product feature would be $200.

Answer 1

We will examine the incremental revenues and incremental costs of the proposal.

a)

Incremental cost =C=Campaign cost+change in production costs=100+(200-100)*5=$600

Incremental revenues=R=(200-100)*7=$700

Net incremental revenue=R-C=700-600=$100

b)

Incremental cost =C=Implementation cost=$250

Incremental revenues=R=Saving in production cost=(5-3)*100=$200

Net incremental revenue=R-C=200-250=-$50

c)

Incremental cost =C=Campaign cost=$150

Incremental revenues=R=(8-7)*100=$100

Net incremental revenue=R-C=100-150=-$50

d)

Incremental cost =C=Campaign cost+change in production costs=200+(150-100)*5=$450

Incremental revenues=R=(8-7)*100+8*(150-100)=$500

Net incremental revenue=R-C=500-450=$50

We observe that net incremental revenue is highest for alternative (a) it should be selected.