Uphill or Downhill? Locating the Firm on a Profit Function

Abstract

When deciding about changes in levels of multiple marketing investments aimed at improving profits, managers need to know whether they are on the uphill side or the downhill side of the profit function with respect to each investment variable. Spending errors made by an uphill-located firm that believes that it is a downhill-located firm can have serious consequences. This article offers an econometric “diagnostic tool” to infer a company's current location on a multivariable profit function and to determine the changes in investments that will take the company to the neighborhood of the maximum profit. The authors apply the proposed approach to daily newspaper industry data and investigate the optimality of companies' allocation behaviors with respect to three marketing efforts: investments in quality, distribution, and advertising space sales effort. A novel feature of this problem setting is that it involves a “dual-revenue” market with possibly interrelated demands for subscriptions and advertising space. The authors derive normative rules for marketing investments in four dual-revenue market types. The empirical analysis finds that daily newspapers' dual revenues are positively interrelated and that a majority of these companies are located near the optimal level of spending for quality, a surprising finding considering that previous studies have characterized marketing managers as overspenders. Indeed, when these companies are suboptimal, they are much more likely to be underspending (i.e., they are located on the uphill side of the profit function) than overspending. In addition, the research furnishes estimates of sales elasticities with respect to quality, personal selling, and distribution investments, which are sparsely available in the extant literature.