Advertising Elasticity of Demand (AED): Definition and Examples

What Is Advertising Elasticity of Demand (AED)?

Advertising elasticity of demand (AED) measures a market's sensitivity to increases or decreases in advertising saturation. Advertising elasticity measures an advertising campaign's effectiveness in generating new sales. It is calculated by dividing the percentage change in the quantity demanded by the percentage change in advertising expenditures. A positive advertising elasticity indicates that an increase in advertising leads to a rise in demand for the advertised good or services.

Key Takeaways

  • Advertising elasticity of demand (AED) measures advertising expenditure's impact on generating new sales for a company.
  • Companies want a positive AED because it indicates advertising efforts resulted in an increased demand for their goods and services.
  • AED may not be the most accurate predictor of advertising's impact on sales because it does not consider other factors that affect demand, such as changes in consumer tastes and spending habits.
  • The price of products and the availability of lower-priced substitutes can also impact consumer demand.

Understanding Advertising Elasticity of Demand (AED)

The impact that an increase in advertising expenditures has on sales varies by industry. Companies frequently review their advertising-to-sales ratio to measure the effectiveness of their advertising strategies. Quality advertising will result in a shift in demand for a product or service. Advertising elasticity of demand is valuable in that it quantifies the change in demand (expressed as a percentage) by spending on advertising in a given sector. Simply put, it shows how successful a 1% increase in advertising spend is for raising sales in a specific sector when all other factors are the same.

For example, a commercial for a fairly inexpensive good, such as a hamburger, may result in a quick bump in sales. On the other hand, advertising for a luxury item—such as an expensive car or piece of jewelry—may not see a payback for some time because the good is costly and is less likely to be purchased on a whim.

Luxury goods have an income elasticity of demand, which means that as people's incomes rise, the demand for luxury goods increases as well.

Calculating Advertising Elasticity of Demand

If you have the required information, you can easily calculate AED. You'll need access to several periods of quantity demanded and advertising expenses. Most people will not have this information available as advertising expenses are generally listed under operating expenses on an income statement, and the quantity of a product demanded is tough to obtain. Many use change in sales or change in demand estimates in the calculation.

Using information from previous periods, you determine the percent change in quantity demanded and spending on advertising. Then, you determine the advertising elasticity of demand for a product or service using the formula:

AED = % Change in Quantity Demanded ÷ % Change In Advertising Spending

Criticism of Advertising Elasticity of Demand

Because a number of outside factors, such as the state of the economy and consumer tastes, may also result in a change in the quantity of a good demanded, the advertising elasticity of demand is not an indicator of advertising's effect on sales. Many confuse AED with showing how advertising dollars affected sales, but sales aren't part of the equation.

Demand and sales are two different metrics—sales are what was purchased, whereas demand is what is desired. Some use demand to refer to the price point at which consumers will buy a product, but again, this is difficult to determine unless surveys are used.

It is difficult to measure demand because you'd have to know what people want at the individual level and what they would pay. Thus, the change in sales is commonly used to replace change in demand, causing AED not to represent its intended measurement—whether a change in advertising affected a change in demand.

AED vs. Price Elasticity of Demand (PED)

While advertising elasticity of demand measures how advertising impacts the demand for products or services, price elasticity of demand (PED) measures how a change in price impacts demand. Demand response to price fluctuations can be deemed elastic or inelastic depending on consumer reaction to the changing prices.

For example, suppose the price of a product increases significantly, but consumers continue to buy the product at the same levels as before despite the price increase. The price elasticity of demand is low or inelastic (that is, it doesn't change). Whether prices are high or low for that particular product, consumers continue to demand the product and their buying habits stay about the same. Goods that are basics required for survival, such as food or prescription drugs, are examples of products with low or inelastic demand.

Conversely, a price increase will result in lower consumer demand if a product has a high PED. As a result, consumers will shift their purchases to substitute products with a lower price point, or they may go without the product entirely. This will often be the case with optional or discretionary purchases that consumers can do without.

Companies that sell goods or services with a high PED may find it challenging to increase sales simply by raising their advertising expenditures. In such cases, trying to achieve a positive AED may be ineffective if the company doesn't address the high price point driving consumers away.

What Does Advertising Do to Elasticity of Demand?

Advertising can increase awareness of a product or service, producing an increase in sales. This does not necessarily reflect an increase in its price elasticity of demand because price elasticity represents a change in demand with an increase in price.

Does Advertising Lower Elasticity?

Elasticity measures how much a price will change in a given scenario. Many products and services have a set price elasticity, but others are more elastic. Advertising doesn't affect a product's price elasticity; it affects awareness and sales.

Does Advertising Cause a Shift in Demand?

Advertising creates awareness and can generate more sales, but doesn't affect demand.

The Bottom Line

Advertising elasticity of demand is a measurement purported to demonstrate the effect advertising has on a market. However, this ratio should be used with caution as an indicator of advertising success because many variables can affect a marketing campaign's success.

Sales may go up or down after advertising, but this does not necessarily mean that demand has changed because demand is not measured in how much of something is sold.