Question

Draw a graph that shows the effect on a firm's profit when it increases spending on advertising but the increased advertising has no effect on the demand for the firm's product.

Short answer

After an increase in advertising costs with no increase in demand, the profit of the firm decreases. This effect can be graphically represented by a downward shift in the firm's profit line.

Step-by-step solution

Identify and label the axes

To start with, a coordinate plane is created. The x-axis represents the quantity of the firm's output (Q), and the y-axis represents the cost/revenue/profit (in dollars).

Draw the initial profit line

Initially, before the advertising costs are increased, the profit line is drawn. This line is calculated by subtracting the total costs from the total revenue (profit = total revenue - total costs). Because the demand isn't affected by advertising, the total revenue line is a straight line.

Adjust the profit line for increased advertising costs

Now, the costs for the firm increase due to higher advertising spending. However, since there is no effect on demand, the revenue does not increase. This results in a lower profit for the firm. The new profit line has to be redrawn to reflect this change, and it will be lower than the previous one.

Illustrate the effect on profit

The difference between the initial profit and the new profit after advertising is the loss the firm took up by investing in ineffective advertising. This change can be represented as a downward shift from the first profit line to the second one.

Key concepts

Demand and Revenue

In the realm of business, **demand** refers to the customer's desire to purchase goods and services at a particular price. It's the heart of the potential earnings for a company. When crafting strategies to influence demand, businesses often turn to advertising, expecting it to lure more customers to their doorstep.
However, in this case, the increased advertising investment does not lead to a bump in **demand**. Consequently, the **revenue**, which is the total income from sales, remains unchanged. This situation serves as a crucial learning point: more spending on advertising does not automatically equate to more demand or higher revenue.
Revenue can be mathematically represented as the product of **price** and **quantity sold**. Here, since neither price nor quantity increases, the revenue line on our graph remains a flat, horizontal line. This fixed line indicates a constant revenue across different levels of production output.

• Key takeaway: Without a demand increase, revenue stays constant, despite higher advertising costs.
• Careful planning is needed to align advertising efforts with actual demand stimulation.

Cost Analysis

**Cost analysis** is a powerful technique businesses use to anticipate the expenses associated with producing goods or offering services. Here, it involves acknowledging a significant increase in costs due to increased advertising expenditure. Proper cost management means understanding where your money is flowing.
In this scenario, the firm's costs rise due to more investment in advertising, but with no corresponding demand impact. It's crucial to grasp how costs can escalate without yielding additional returns if not strategized effectively. These heightened expenses can include:

• Production and raw material costs
• Administrative costs
• And most importantly, advertising expenses

Elevated advertising spending elevates overall costs and depresses profits, as reflected in the graph. The cost line, which usually consists of a fixed component (unaffected by output) and a variable component, sees a rise in the fixed aspect because of advertising. Therefore, it results in a shift upwards in the total cost line, even though the demand remains unchanged.

Profit Graph

A **profit graph** is a visual tool aiding in the comprehension of how profit changes in response to different factors. Here, we plot profit, represented as the difference between revenue and costs on a graph. Initially, a firm's profit is portrayed as a line or curve based on its costs and revenue.
In this scenario, due to the extra, ineffective advertising, the profit graph undergoes a transformation. With advertising being ineffective in raising demand or revenue, yet successful in increasing expenses, the profit curve is effectively **shifted downwards**. The result is a new profit line indicating reduced profitability.
This change is starkly represented in the graph, where the new profit line is lower than the original. Such a visualization aids business leaders and students alike in deeply understanding how ineffective advertising can negatively impact profits by raising costs without increasing revenues.

• Visual representation is key to understanding effective vs. ineffective advertising impacts.
• Profit graphs highlight the crucial need for strategic advertising decisions.